Research unbundling a watershed moment for industry

A speech by Financial Conduct Authority head Martin Wheatley, in which he outlined the UK regulator’s plans to reform research and execution payments, represents a “watershed moment” for the industry.

A speech by Financial Conduct Authority (FCA) head Martin Wheatley, in which he outlined the UK regulator’s plans to reform research and execution payments, represents a “watershed moment” for the industry.

His keynote speech at the FCA’s asset management conference last week revealed that the watchdog is significantly accelerating its efforts to resolve conflicts of interest in the asset management industry, targeting in particular radical reform of  how buy-side firms source and pay for research from brokers.

Last November, the FCA’s predecessor, the Financial Services Authority, sent a ‘Dear CEO’ letter requiring heads of asset management firms to take personal responsibility for reducing potential conflicts of interest, including those relating to the use of commission payments to pay for corporate access. But last week’s speech raised the prospect of a clear separation of payments for execution and research, and asset managers paying for the latter out of own rather than client funds.

“Martin Wheatley’s comments last week have really taken what was just one aspect of last November’s letter to asset management CEOs and pulled it out as something the FCA will be focusing on,” said Adam Toms, CEO of Instinet Europe.

The central thrust of Wheatley’s speech – which is expected to form a major part of a consultation paper the FCA is due to publish before the end of November – was to reduce end-investor costs by forcing asset managers to make conscious cost/benefit-based decisions about which research to buy and which brokers to execute with.

Toms added: “Clients have already been moving in this direction since last November’s letter, with many looking at ways to enhance their transparency and the delineation of how they pay for services and this will cause many to review what they’ve already done and look to accelerate the process. Firms should always be looking to exceed what the regulators expect.”

Management fee pressure

However, perhaps the more significant change for the asset management community is the proposed reform to the way research is actually paid for.

At the moment, asset managers pay commission to brokers from their fund which is also used to pay for research. Wheatley said that this is distorting the cost of research and making firms complacent about the cost and quality of the research they receive.

“The link between volume of trading and research expenditure appears to be flawed. It creates ‘pots’ of research commissions the fund manager is then incentivised to spend regardless of the added value of the services,” he said.

Richard Balarkas, a consultant and former global head of AES sales at Credit Suisse, claimed the shift to paying for research from management fees instead of using client money will be a major change for the buy-side.

“This is really a watershed moment for the industry and it will require a big shift in mind-set from the buy-side as they will really need to think about how they’re spending money on research and what the price of research should be,” Balarkas explained.

While the buy-side will see a major change in the way it sources content and execution services, the sell-side is set to be even more impacted by the change.

Claiming the current system of bundled commission payments is helping to support what he called “unsustainable” businesses, Wheatley indicated the FCA fully expects some firms to exit the market as a result of the regulator’s plans.

More scrutiny

One buy-sider told that a shift to using management fee money to pay for research would lead to a reduction in the amount of research purchased and more scrutiny of its price and quality. A significant reduction in research spend across the industry would see many sell-side firms under pressure to either make their research and execution business competitive or shut down.

Balarkas agreed that increased focus on cost of research by the buy-side would lead to casualties: “Overcapacity in the research market has been a problem for a long time and moving to an unbundled regime will certainly result in some providers exiting the market completely.”

While is might seem bleak for some sell-side firms, Instinet’s Toms was more positive about the FCA’s work and believes firms have already shown willingness to change their business for the better in line with the regulator’s expectations.

“This is a big cultural change for the industry and it’s not going to happen overnight but we’re starting to see discussion of these issues on the Street and brokers are changing from the way they operated in the past,” he said.