This is Part 1 of a 2 Part Research Note, which describes how regulation and market pressure is forcing transparency on equities research and how that is leading to cost pressures on the research business.
In Part 2 on Friday, we will look at possible technology solutions and business model innovation that can bring lower costs through automation and open up new market opportunities, in order to alleviate pressure on the bottom line.
Who pays for equities research?
Historically it was the sell side that paid for research. That got hammered after the Dot Com bubble burst, when it became clear that there were too many conflicts of interest if the sell side paid for research (investment bankers were publishing sales pitches disguised as research).
Then the buy side started paying for research. This was better, as the buy side was not conflicted and they benefited from good research. However this was not done in a transparent manner. Funds paid via commissions on brokerage fees. Well actually the Fund’s customers paid, which is an issue that the regulators are now focused on.
The European Commission proposed that asset managers “unbundle”, meaning that they have to report how much they are spending on third-party research via Commission Sharing Agreements (CSAs) with brokers. The UK’s Financial Conduct Authority (FCA) has suggested that it wants to ban CSAs.
This now forms part of MiFID II’s clampdown on third-party inducements and time is running out. This comes into place at the start of 2017.
This is likely to go global very quickly if it happens in Europe, because the admin burden of reporting in different ways in different jurisdictions is too hard. In other words, an American or Asian Fund that wants European investors may offer the same transparency to their American or Asian investors. In the end, market pressure from investors will replace regulatory pressure. Once investors get educated about fees, they demand lower fees.
We envisage three future scenarios:
- Scenario # 1. Asset Managers bring more research in-house. If Asset Managers want proprietary research for a competitive advantage, bringing research in-house makes sense. If their customers refuse to pay for research and they have to pay for research out of AUM, they might as well budget for research as part of their core operating expenses. This will make them highly motivated to look at automation as a way to cut costs.
- Scenario # 2. New micro research firms emerge. New technology and new low cost digital distribution channels will enable these new micro research firms to come to market at very low cost and thus offer lower cost high quality research services. Some will be almost in-house by offering exclusivity within domains (accentuating Scenario # 1). Some will offer free high quality research as part of a content marketing strategy to win clients (accentuating Scenario # 3).
- Scenario # 3. Free research gets better. Free research maybe monetized by advertising (the old model before Ad Blockers) or higher value services (using the open source to Freemium direct revenue model). The free layer will gradually encroach in quality terms on what is now a paid for service, raising the bar for everybody. The new micro research firms will both produce some of this free research and will also use the free research from others to keep their costs lower.
It is likely that the future will bring a mix of all three scenarios and that new value chains will form around these scenarios.
The future scenarios will be enabled by new technology and business model innovation that enables new players in the value chain to a) reduce cost via automation b) open up new markets that were too price sensitive earlier. We will address this in Part 2 on Friday.
Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech.