New models for buy-side research

The need for a new model to enable the buy-side to purchase research was one of the hot topics discussed at an Investment Management Association (IMA) event in London last week.

Research has become a key battleground among those vying for buy-side custom as commission sharing agreements (CSAs) - which let investors pay for independent research through executing broker commissions - continue to thrive.

In 2011, non-execution services made up around two-thirds of the global US$33 billion commission spend.

However, regulatory scrutiny of this area has been generally low compared to execution services, despite the significant potential for bad research to negatively affect returns.

In the UK, the research landscape has also been affected by a recent regulatory push to further separate broker commissions for research and execution, which has added to the growth in CSA usage.

Despite this, there are several factors that maintain an uneven playing field.

One of the biggest barriers to a truly competitive research market in the UK is VAT. Currently, a buy-side firm paying for research through broker dealing commissions does not attract VAT, but buying research from independent, specialist research houses that are not connected to execution, does attract 20% VAT, making it tough for independents to compete with the brokerages.

Although CSAs have helped, there is still a chasm of opportunity the larger players enjoy that separates them from independent research houses.

Research presented at the IMA event by Neil Scarth of Frost Consulting, found that CSA use grew from a little over 5% of all US and European trades in 2005, but climbed rapidly to almost 15% by 2008 and this pace has accelerated since the beginning of the financial crisis and is estimated to reach 48% this year.

At the same time, investment bank research budgets have shrunk, going from a peak of US$8.2 billion at the end of 2007 down to US$4.8 billion today.

Buy-side participants called for a new model under which bespoke research can be purchased from independent researchers without the need to go through an executing broker, or face 20% VAT.

For such a model to emerge, the industry itself must band together to forge a path forward, as regulators will likely avoid such measures as they focus on transparency and reducing conflicts of interest between buy- and sell-side firms.

For now, though, CSAs will have to do.

But, buy-side be warned - the CSA also carries risk in a way that independent commissioning research might not. There is an element of counterparty risk, as evidenced when Lehman Brothers collapsed and millions in CSA commissions were trapped. There is also an FX risk depending on which CSA broker and research provider is being used. Lastly, there is the risk of information leakage, as CSA brokers can see which research buy-siders are paying for, hinting at their strategy.

There are already barriers to using independent research and differing VAT treatment of independent providers is exacerbating this problem. The FCA should work with the Treasury to ensure that market research providers are all able to compete on the same terms, which should bring benefits to both markets and investors.