Rethinking research

It’s been a hard year for the sell-side, with increased focus on market stability driven by major technology glitches, lower trading volumes and a desire from buy-side clients to make more use of commission sharing agreements (CSAs). But things could get even tougher on the research front.

The sell-side investment research model could be on its last legs, as buy-side traders look for a new approach to research. As such, brokers may need to completely overhaul their somewhat timeworn research model.

Indy Sarker, CEO of US trading technology firm ANALEC, for one, believes the structure of research offerings is skewed towards a small subset of names, rather than across the market. In a report authored by Sarker, he warns that sell-side research needs to move with the pace of change other parts of the industry have experienced.

Presently, a fund manager could receive up to 35 research notes on an earnings update for a large-cap stock like IBM, whereas only two or three are needed, Sarker contends.

Part of the new research landscape for equities should include a further focus on small- and mid-sized companies, in addition to the market’s most liquid stocks that generate market share. But the research did note that many smaller cap stocks fail to generate sufficient commissions to justify coverage.

In addition to the value of broker research dwindling as it becomes more commoditised, Sarker believes better separation of investment banking and research raises the possibility that greater use of unbundled commission payments by money managers will lower the amount of money they pay to the sell-side for research.

With a shrinking commission pie and the growing importance of program trading, which doesn’t rely on research, the sell-side needs to adapt in line with buy-side demands, Sarker states.

“Sell-side research has to move away from silos (i.e. equities and fixed income as separate units) and deliver insights and investment opportunities that look to arbitrate the capital structure of the organisation,” Sarker writes.

The rise in CSAs in particular should be worrying sell-side research desks, as they’ve steadily grown in popularity over recent years, with US$2 billion going through CSAs out of a total commission pool of US$11.6 billion in 2011, according to figures from consultancy TABB Group.

In the UK, another trend driven by regulators is expected to dramatically alter the provision of research from the sell-side.

In October, UK regulator the Financial Services Authority began a crackdown on buy-side firms to unbundle commissions for research and execution services, which will pressure the sell-side to alter how research is organised and sold.

While this approach to separate commission payments is not high on the list for US regulators, similar changes to the research environment may occur, driven by shifting buy-side needs for more tailored research. Combined with a wealth of regulatory change on the horizon, the new year may bring more challenges to the sell-side that initially expected.