RETHINKING
THE RESEARCH
FUNCTION
How can investment banks use digital technologies to make research profitable?
Aside from unique insights provided by a limited number of specialized boutiques, non-differentiated sell-side research is not something the buy side has typically needed or wanted. As the research landscape evolves, and new digital technologies and competitors emerge, investment banks have an opportunity to leverage their data in new ways and earn money managers’ increasingly limited research budget dollars.
The research business
model is bad
Historically, investment banks have chosen to give away research for free in the hope of attracting trading commissions in the future. In turn, they used investment banking fees from initial public offerings (IPOs) to support research activity.
That all changed with recent regulations, which set out to separate research from investment banking activities and prevent companies from disclosing information to research analysts before it is publicly available. As a result, the opportunity of sell-side analysts to provide quality research and alpha-generating ideas has been greatly diminished.
Electronification is changing the game
The rise of electronic trading and alternative trading services has driven equity trading margins to nearly zero. There is some speculation that the buy side is actually paying for research with “tack-ons” to base execution rates, but the reality is that any incremental revenue is minimal and shrinking.
Even for high-touch, agency-bundled US equity trades, commission rates averaged just 3.58 cents per share in the first quarter of 2014 (Greenwich Associates). Electronic trade is rapidly becoming an important part of the trading landscape for Fixed Income, Currencies and Commodities (FICC) too, slowly pushing this market toward the same fate as the equities business.
Average commission rates for US equity trades ranged from 1.07 cents per share to 3.58 cents per share in the first quarter of 2014.
Source: Greenwich Associates
Information has been commoditized
In the past, sell-side analysts had access to information that was not readily available to the general public. More important, they often had exclusive access to information deemed material to the business results of the companies they covered.
New regulations and the internet have changed all that. Regulation Fair Disclosure prevents companies from disclosing information to analysts unless it has already been made publicly available; and the internet has exponentially increased access to information for everyone. Small players with low-cost structures and innovative business models are taking advantage of these low barriers to entry to join the research space.
MiFID II will increase selectivity
In January 2018, the Markets in Financial Instruments Directive II (MiFID II) rules designed to separate broking, or trading, from research fees are expected to take effect. Many fear that these rules could have a profoundly negative impact on the investment banking industry’s research revenue.
MiFID II will force asset managers to pay for research services out of pocket or carve out a separate research budget with investors, instead of passing on costs through the price of securities. Faced with the true price of research, money managers are likely to be more selective when choosing research providers and more critical of the services provided.
Research budgets could shrink by 25 to 30 percent, or $15 billion, post MiFID II implementation.
Source: Quinlan & Associates
Conclusion
Sell-side research is one of the most challenging issues facing the investment banking industry.
As the research business model continues to shift in response to trading electronification, information commoditization and new regulation, banks must evolve.
Sell-side firms have access to vast quantities of historical and real-time market data that have the potential to create meaningful research products and services. By tapping into new data sources, including social media, and leveraging advanced analytics, including sentiment analysis, firms can reinvigorate the research function and create alpha-generating trading strategies with a monetary upside.
Get in touch
Bob Gach
New York
Owen Jelf
London
