BREAKING APART.

Lynn Strongin Dodds looks at the unravelling of research from execution.

MiFID II may be delayed until January 2018 but the repercussions in the soon to be unbundled world are already being felt. Some brokers are already whittling down their research ranks and products while others are seeing their leading lights jump ship to their buyside compatriots.

Most notable examples are Nomura which has practically withdrawn from most of its European equities business while Huw van Steenis, the high profile analyst at Morgan Stanley, was the latest to move to the other side – in this case to Schroder’s, the UK’s largest listed asset manager. This followed Royal Bank of Scotland’s macro credit strategist Alberto Gallo’s and Jefferies head of sales trading Gavin Phillips, both of whom are now ensconced in New York-based hedge fund companies.

Further consolidation is also on the horizon in the wake of the Lombard Research and Trusted Sources merger this past summer. Independent and niche firms may need to join forces to better compete against larger investment banks who, albeit diminished in some cases, will still be strong contenders for a dwindling pool of business.

“The general theme with brokers is if they do not think they can be ranked top five in a particular sector for research it will be uneconomic,” says Steve Grob, director of group strategy at Fidessa. “That is, and will continue to trigger, a shake-up in the industry. We are already seeing sellside analysts move to buyside firms, but it will also create a band of star analysts within the sellside with the mediocre ones struggling to find a place.”

Richard Parsons, CEO of Instinet Europe also believes the “sophistication and granularity of broker reviews will increase, as the need for governance around research payments heightens. Furthermore, the distribution and consumption models of investment research are evolving with the sellside having to adjust resources accordingly. Our own CSA statistics support the view that the market has already started to embrace unbundling.”

Although the hope is that asset managers will benefit from more targeted and relevant research, they will not escape unscathed. They will not only have to reassess their needs but also reconfigure their research payment processes. Currently, roughly 75% of European buysides pay for research via commission sharing agreements (CSAs), but the new rules will place greater onus on firms to demonstrate that the charge is separately identifiable to the client and that they have robust processes in place for tracking and measuring their research expenditure.

The route to payment

According to a paper from Fidessa – Unbundling: Picking the right option – there are three well defined payment paths to select, but determining which one is the most suitable between a fund manager and a broker, while still giving the best service to the end investor, is proving challenging. This may help explain why almost half of the 100 asset managers recently canvassed by EY were still sitting on the fence.

It found that only around a quarter of asset managers are likely to imitate some of the behemoths such as Woodford Investment Management (headed by luminary fund manager Neil Woodford), M&G Investments and Baillie Gifford, who are funding the research out of pocket and not charging clients.

The majority are likely to either choose the second option – pre-determining a budget using client money put into a research payment account (RPA), or the third which involves making payments into the RPA which can fund research using commission payments, but in a more controlled manner than at present.

Market participants also expect to see a combination of the two but there is a general concern over the operational burden of setting and managing research budgets at the individual fund level, especially those with a large number of funds, according to Jeremy Davies, co-founder of RSRCHXchange, “I think that the CSA with an administrative account will be the most popular but as with all these things, the devil is in the detail.” He adds, “The question is how do you collect payments from different funds with the same strategy and how do you spread them evenly across the year.”

Neil Scarth, principal at Frost Consulting also believes that “the vast majority of the buyside will chose a CSA and RPA structure because paying for research from their own P&L will have a significant impact on their profitability.” He says, “We have seen some people move to the so called Swedish model where an agreed research charge is deducted from the fund on an accrual basis and transferred to the RPA.”

He adds, “I think it works best for fund managers that are owned by banks because the costs can be controlled, but some third party managers may be reluctant to ask asset owners for additional research funding which would require operational changes for both parties.”

JP Urrutia, European general counsel at agency broker ITG also believes the structures and reverberations will depend on the country in which the fund management group is based. “In the UK, the effect will be a small tremor because the country has been moving in this direction for some time,” he adds, “however, if it is a country such as Germany it will be closer to a seismic change because they will need to show greater transparency in terms of how research is paid for the first time.”

The French will also have to make some adjustments. The Autorité des Marchés Financiers (AMF) has been one of the first out of the gate, issuing a weighty 88-page consultation in September with feedback expected back by late October. The regulator has been a vocal proponent of the CSA model provided there are additional checks and controls in place for monitoring and measuring. The fear is that full unbundling would favour the larger UK asset managers at the expense of smaller French firms.

By contrast, the UK Financial Conduct Authority (FCA), which is set to publish its consultation at the end of September or beginning of October, has been a proponent of a complete ban on trading commissions. The FCA has been a driving force behind the regulation and has been conducting spot checks on the asset management community to get a better handle on how the system is working.

“The language used by the European Commission was in itself quite prescriptive, which may in turn lead to more literal and therefore consistent transpositions at a national level,” says Parsons. “This consistency could support a more harmonised approach to the choices made by our clients across the region.”

Looking ahead, as with any major change, there are and will continue to be waves of innovation, especially on the research platform front. There are already variations on a theme emerging, with RSRCHXchange launching last year to enable fund managers to buy research from a variety of providers using subscriptions, cash or research payment accounts.

“If you look at the products in the marketplace, aggregation is done quite well by companies such as Bloomberg, Reuters and Markit Hub,” says RSRCHXchange’s Davies. “However, if you turn the clock forward 15 months, that type of aggregation doesn’t work. It requires an entire rebuild to incorporate payment capability”.

Smartkarma is also trying to change the way institutions create, distribute and consume research, by becoming the “Spotify for investment analysis,” according to co-founder Jon Foster. “We are analogous to a music streaming service because we charge the end user a flat subscription fee to gain access to the content provided by a large body of independent research providers”

The firm employs an algorithm to help determine the slice of the revenue pie each analyst should receive every month. This means that analysts are measured by metrics such as the amount of engagement their insight generates. Increased engagement provides clients with a clear indication that a piece of research is of high quality, as it is generating discussion. This also creates a more collaborative environment, facilitating new discoveries that are only made by analysts working together across traditional boundaries.

Although to date most of the activity has been focused on Europe, global firms will not be immune from the changes. “Many market participants will want to keep the status quo but the direction of travel is clear,” says Mark Pumfrey, head of EMEA at Liquidnet. “The buyside is heading towards commission unbundling because the regulators and policy makers, and the underlying investors, want greater transparency into the value of the research consumed.”

©BestExecution 2016

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