Regulatory change is driving new approaches in asset manager research procurement process and in turn, the technology of the research that serve them. A process begun in the UK has evolved into a global debate about research funding. The final act in this saga may be pan-European legislation (due in 1Q 2018) that vastly transforms the global research payment market with substantial implications for all investment bank research producers.
In November 2012, the UK regulator began a process to force asset managers to be more careful with the client commissions they spent on research. A study conducted by the UK FSA found that many managers were less careful in spending client commissions than they were with their own funds. The regulator’s logic was that increased discipline on the part of the asset managers would lower research costs for the end saver, thus increasing returns.
Institutional equity research is a very unusual market, in which asset managers spend their clients’ money to buy research. Most of it is produced by investment banks, has no specific price and is not governed by purchase contracts. Rather, banks make the research available to asset managers at no specific cost, and hope to be rewarded with an unspecified level of equity execution commission.
The November 2012 document, “Conflicts of Interest” mandated that asset managers construct monetary research budgets rather than employing more variable, theoretically infinite “broker vote” systems. This was an attempt to get asset managers to be much more specific about the research products they were buying rather than the historic practice of receiving large amounts of unsolicited research and paying variable amounts for it. At the same time, commission unbundling, or the relatively recent ability of asset managers to use commissions to buy non-investment banking research products, created a further element of competition for the investment bank research producers.
The UK regulator promised a further review and released new rules in May 2014. They mandated that asset managers must:
a) Place a value on research they bought with client commissions. (This was a challenge as most investment banks will not price the research specifically).
b) Not use commission to buy research they didn’t use. (This was a challenge because banks regularly flooded asset managers with thousands of unsolicited research documents, a fraction of which were actively used).
The net result of these measures will be lower asset manager research spending. Faced with finite research budgets, asset managers will have fewer, but deeper relationships with their key investment bank research partners. This will develop into a two-tier “Premium-Freemium” investment bank research market in which important asset manager clients – those that have chosen the bank as a key research supplier, will expect more sophisticated, interactive and customized research products than those asset managers that haven’t “purchased” the service. Bank research products that do not offer, customization, multi-channel distribution (including mobile) and inter-activity, will lose market share.
At the same time, banks will want to “advertise” to non-clients, increasing the importance of research “findability” as asset managers deploy more sophisticated search technology to manage their large research corpuses.
As a result of commission unbundling, bank research producers are competing against thousands of non-bank research producers that can now receive commissions in payment. Bank research producers will have to have better products to stand-out against this wider data set.
With the UK FCA now having created its final rules (for now) the next phase of the regulatory process in Europe shifts to MiFID II – the pan-European securities legislation that will apply across the EU in 1Q 2018. One of the very controversial aspects of the current draft is that it appears to potentially ban the use of commission entirely for the purchase of research. If that were to happen, investment bank research would immediately, and globally, be moved to a specifically priced market.
With the variable payment mechanism of equity commissions removed, banks would have to either price their research products, or provide it for free, which would not be sustainable.
This would revolutionize a decades-old model. Some investment banks are already responding to these dramatic changes by investing in new production systems to leverage multi-channel formats like HTML5 in order to attract, retain and maximize the profitability of their research clients. This is a level of research product innovation that exists in other markets – which investment research has largely avoided – until now.