Yet Another Insider Trading Bill

March 30th, 2015

A member of the U.S. House of Representatives Financial Services Committee introduced  a bipartisan insider trading bill, the third offering on the topic introduced in Congress in recent weeks.  The latest version is more balanced than the Senate version and benefits from a Republican co-sponsor.

Congressman Jim Himes (D-CT) introduced the Insider Trading Prohibition Act which is co-sponsored by Reps. Steve Womack (R-AR), Carolyn Maloney (D-NY) and Emanuel Cleaver (D-MO).  Himes’ district in Connecticut includes Greenwich and Stamford, the epicenter of the U.S. hedge fund industry.

The proposed legislation keys on the concept of ‘wrongfully obtained’ information.  The law would make it unlawful for a person to trade on material, nonpublic information when the information was wrongfully obtained, or when the use of such information to make a trade would be deemed wrongful.

The bill defines ‘wrongful’ as information that has been obtained through “theft, bribery, misrepresentation or espionage, a violation of any federal law protecting computer data or the intellectual property or privacy of computer users, conversion, misappropriation or other unauthorized and deceptive taking of such information, or a breach of any fiduciary duty or any other personal or other relationship of trust and confidence.”

Like the other proposed insider trading bills, the impetus behind the legislation is to remove the personal benefit requirement outlined in the U.S. Second Circuit Court of Appeals ruling on United States v. Newman. The bipartisan bill would make anyone receiving ‘wrongful’ information liable so long as they were aware, or recklessly disregarded, that the information was wrongfully obtained or communicated.

The bipartisan legislation has a more narrowly defined definition of inside information than the blunderbuss approach of the Senate bill which deems all material non-public information illegal.  In this House version, inside information would need to breach a fiduciary duty or “any other personal or other relationship of trust or confidence.”  This definition is not far from the definition of inside information in the other House bill introduced by Representative Stephen Lynch (D-MA) a fellow member with Himes of the Financial Services Committee.

The phrase “any other personal or other relationship of trust or confidence” widens the scope of confidential information, creating some headaches for anyone doing primary research, but it is common practice to have controls which filter out information which breaches fiduciary duties.  These controls can be tightened, a far preferable outcome than having to toss primary research altogether.

As we have noted previously, it is still too early to know which of the three flavors of insider trading bills will prevail, or whether any bill will make it out of committee before the Supreme Court weighs in on Newman.  The bipartisan nature of the latest bill increases the odds that Congress will pass insider trading legislation.  We hope it also increases the odds that a more balanced insider trading definition than the Senate’s would succeed.

The text of the legislation is available here.

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FCA Releases Its Business Plan for 2015/16

March 29th, 2015

The UK Financial Conduct Authority (FCA) submitted a business plan for 2015/16, calling for a 6% increase in its budget to £479 million (US$766 million).  The 84-page plan outlines the regulator’s initiatives for the year.  At least three initiatives involve the hot topic of investment research payments.

The FCA plans to launch an asset management market study for delivery sometime in 2016 which will examine the charges paid by investors and the factors that drive those charges.  Client dealing commissions, incorporating payments for investment research, will undoubtedly be included in the study.

The FCA will also be implementing the technical standards developed in MiFID II, including those affecting payment for research, once the Directed Acts are finalized by the European Commission in June.  It is still unclear whether the FCA will ‘gold plate’ the MiFID II provisions relating to research payments if it feels they do not go far enough in severing links to client dealing commissions.

The regulator plans to assess firms’ practices related to inducements and conflicts of interest, but this review seems to be focused primarily on retail investment advice, not research payment issues.

The FCA will be hosting the 40th IOSCO Annual Conference in London in June 2015, the same time when the European Commission will be releasing MiFID II technical advice.  The FCA has indicated separately that it intends to raise the issue of research payments with its IOSCO counterparts.

Although the FCA has a lot on its plate for the coming year, it is clear that reforming the payment process for investment research will not be neglected.

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Industry Veterans Start New Short Ideas Research Boutique

March 23rd, 2015

Late last year, a few research industry veterans set up a brand new short-biased independent research firm called Pacific Square Research (the firm was initially called GVB Research).  Now that the firm has rolled out its research product and has a number of clients paying for its service, we have decided to provide our readers with a more extensive profile of the firm.

What Does Pacific Square Research Do?

Pacific Square Research (PSR) is a short-biased independent research firm that focuses on fundamental, investigative and forensic analysis of North American mid and large cap companies. Their research process involves the discovery, deconstruction and reconstruction of the ideas they have identified.  PSR’s goal is to identify and research actionable names with targeted valuations they believe represent, for shorts, a potential decline of at least 30% to 50% from current levels.

The two principals of the firm – Herb Greenberg and Donn Vickrey – personally conduct all of the research, working on the same names each coming from their own unique perspectives.  PSR ferrets out fraud, fads and failing business models.  The firm’s goal is to highlight at least 20 new names a year they feel strongly about.  They won’t conduct maintenance research merely for the sake of covering names and meeting a quota.  They publish quality over quantity.

A few of the services that PSR provides includes full research reports (Pacific Square Reports); updates to the ideas they have identified (Pacific Square Updates); a list of the companies on PSR’s internal watch list (Pacific Square Alerts); and limited custom fundamental and forensic research for an additional charge (Pacific Square on Demand).

What Makes PSR Different from Other IRPs in the Same Space?

According to Integrity’s classification, there are three major types of short-biased research including qualitative research firms, quantitative research firms, and hybrid firms.  Based on PSR’s research process, we would identify them as a qualitative short-biased research firm.  Two of the more successful firms in this space include Off Wall Street and Assay Research.

PSR is unique as it combines Herb Greenberg’s investigative journalism experience with Donn Vickrey’s background as a nationally recognized forensic accountant and certified fraud examiner.  While PSR isn’t looking for frauds, per se, they believe they will “know one when they see one” – and will probably be able to identify it with more certainty than most.

What is PSR’s Commercial Model?

PSR is not a Registered Investment Advisor or a Broker-Dealer, nor do they trade their own names (like some short-ideas providers).  Instead, PSR provides their research to customers based on a subscription model at institutional rates.

While the firm does offer prospective clients samples of their work, they do not provide free trials to their research.  On occasion, PSR will do custom forensic research for clients.  Customers pay for PSR’s research either using hard dollars or through CSAs established with their executing brokers.

Who is PSR’s Target Market?

PSR’s research product is targeted primarily at U.S. focused long/short equity hedge funds, mutual funds, family offices, insurance companies, auditors, and law firms — any fund or entity looking to find new short ideas or a spot trouble in their portfolio.

Based on Integrity’s assessment, there are approximately two dozen independent short-biased research firms currently in existence around the world serving the same marketplace as PSR, generating total revenues of between $80 mln to $100 mln, with the bulk of the business coming from US-based asset managers.

What is PSR’s Next Major Target/Milestone?

Like a few of PSR’s peers, the firm has adopted a restricted business model where they publish research for a limited number of buy-side customers.  PSR intends to close off subscriptions to its research service this year once they reach approximately 35 clients.

What are a Few Interesting Facts about PSR?

The two founders of PSR, Herb Greenberg and Donn Vickery, both have extensive experience in the independent research industry.  Before working for CNBC and TheStreet, Herb was the Co-Founder and President of indie research firm Greenberg Meritz Research & Analytics.  Donn Vickery was also the Co-Founder of Gradient Analytics (previously known as Camelback Research Alliance) which was eventually acquired by quantitative research firm, Sabrient Systems.

PSR is a short-biased firm that can proudly say, that as of this writing, three of the five names they have published on since launching several months ago are in the money (at least for now)!

PSR Contact Information

Adam Roberts
Director of Sales and Marketing
Pacific Square Research

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Instinet Embraces Hard Dollar Payment Regime

March 17th, 2015

Instinet Europe announced its application as a Payment Institution with the Financial Conduct Authority (FCA), reflecting regulatory efforts to change the way asset managers pay for research. The application positions Instinet to benefit if the final MiFID II rules prohibit research payments using client dealing commissions.

Instinet is seeking regulatory authorization to be an outsourced provider of “research payment accounts” (RPAs) which under proposed MiFID II guidelines would be a mechanism for charging asset owners for research services without using client dealing commissions.  Since it is not clear yet whether the final MiFID II rules will allow research payments through existing commission sharing agreements (CSAs), Instinet’s action is a hedge for its own commission management business.

Separately, Instinet said its CSA balances have doubled over the past year and hit a record high in February 2015.

Instinet’s designation as a Payment Institution would enable it to offer a new segregated cash management and payment service solution to clients who choose to operate a hard dollar ‘research payment account.’  Instinet views RPAs as complementary to its existing Commission Management business, presumably sharing some of the capabilities such monitoring pool balances and payments to research providers.

Our Take

The entry of players such as Instinet helps to address concerns about the feasibility of implementing a new research payment process in prior to the January 2017 deadline when MiFID II will go into effect.

At the same time, the FCA has expressed reservations about using investment banks for the administration of research payments.  Although Instinet operates as an agency broker, it is a subsidiary of the Nomura Group.

Instinet’s move is savvy.  It steals a march on investment bank competitors, many of which are actively lobbying the European Commission to forestall a ban on research payments using client dealing commissions.  Even if the final MiFID II language permits the use of CSAs to pay for research, the FCA may choose to implement a more stringent hard dollar regime in the UK, which would put Instinet in the catbird seat.

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Proposed U.S. Legislation Would Ban Primary Research

March 16th, 2015

Two Democratic U.S. senators introduced proposed insider trading legislation which is extremely broad and would effectively ban primary research.  Separately, an insider trading bill introduced in the House of Representatives has a more narrow definition — although broader than the current common law definition — and would not have the same effect on investment research.  It is still too early to say how either bill will fare.

Stop Illegal Insider Trading Act

U.S. Senators Jack Reed (D-RI) and Bob Menendez (D-NJ), two senior members of the Senate Banking Committee, co-sponsored the Stop Illegal Insider Trading Act which aims to define the offense of insider trading with a bright line rule: if a person trades a security on the basis of material information that he or she knows or has reason to know is not publicly available, then he or she has engaged in unlawful insider trading.

Under the Stop Illegal Insider Trading Act, it would be irrelevant whether a trader knew of a source’s fiduciary duty or whether the source derived any personal benefit for tipping the inside information.  What would matter is whether the trader knew or had reason to know that he or she had an “unfair advantage” in obtaining material information that was not shared with the broader public.

The bill also would prohibit anyone from communicating non-public information if it was reasonably foreseeable that someone would trade on it.

Ban Insider Trading Act

Representative Stephen Lynch (D-MA), a member of the House Financial Services Committee, introduced legislation to make it illegal to trade “based on information that the individual knows or should know is material inside information.” Inside information is defined more narrowly than the Senate bill:

“The term ‘inside information’ means information that is –

(i) nonpublic; and

(ii) obtained –

(I) illegally;

(II) directly or indirectly from an issuer with an expectation of confidentiality or that such information will only be used for a legitimate business purposes; or

(III) in violation of a fiduciary duty.”

In other words, it would be legal to obtain non-public information provided you did not get it illegally (such as hacking), or from an issuer with an expectation of confidentiality or in violation of a fiduciary duty.  The big change from the current common law definition is that the House bill does not require “a personal benefit to any party.”  It also says that anyone who “intentionally discloses without a legitimate business purpose” inside information to another person is guilty of insider trading.

Reaction to 2nd Circuit Ruling

Both bills are a reaction to the December ruling by the 2nd U.S. Circuit Court of Appeals in New York which said that prosecutors must prove a trader knew the source of a tip received a benefit in exchange for the information.  The court also narrowed what constitutes a benefit, saying it must be of “some consequence” and cannot be only friendship.

The ruling has led to a reversal of convictions or the dropping of charges for seven of the 93 insider trading defendants pursued as part of a crackdown by Manhattan U.S. Attorney Preet Bharara’s office since 2009.


Policy research firms in Washington tell us that Republicans have not decided whether they support insider trading legislation or would prefer to leave the law to the courts.  It is likely that the Second Circuit ruling will go to the Supreme Court.  Congress may choose to wait for that process to finish before moving forward with legislation.

Washington sources will be watching Senator Chuck Grassley (R-IA) as a bellwether because Grassley has been proactive on insider trading related topics.  In addition, the House Financial Services Committee will be hearing testimony from SEC Enforcement later this week and Representative Lynch, who is a member of the committee, will almost certainly prompt discussion of his bill.

Our Take

The proposed Senate bill would equate primary research with insider trading.  Primary research seeks to identify non-public information without the use of insiders, relying on sources such as industry experts or market research on the upstream or downstream supply chain.  Expert networks, channel checks and other primary research techniques are set up to uncover information that is not yet widely known or incorporated in financial markets.

One type of primary research uses investigative journalists who by definition are trained to uncover non-public information.

Regulators and prosecutors have increasingly embraced a vision of creating a ‘level playing field’ in which less informed investors would not be harmed by better informed investors.  The Senate-sponsored Stop Illegal Insider Trading Act seeks to guarantee that all investors would participate on a level playing field.

A wholesale ban on primary research would make the U.S. stock market less efficient.  Analysts would be constrained to use only information which publicly traded companies choose to release.  Techniques to independently test or challenge information from publicly traded companies would be largely banned.  Misleading or fraudulent information from public companies would be more persistent, and ultimately more damaging to investors when dis-proven.  In other words, the U.S. stock market would begin to resemble the Chinese stock market where fraudulent public companies are not uncommon.

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Wall Street Job Outlook Brightens During February, but…

March 11th, 2015

The improvement seen in the overall employment picture over the past few months was evident in the financial services industry in February, according to a private jobs survey.  Layoffs at Wall Street banks and brokerage firms plunged while new hiring surged during the second month of 2015.  However, the right sizing seen for much of last year doesn’t seem to be over for a few large investment banks.

February 2015 Challenger, Gray & Christmas Report

According to the Challenger, Gray & Christmas monthly Job Cuts Report released last week, the financial services industry saw a 67% drop in planned layoffs from 5,375 layoffs announced in January to 1,800 layoffs announced in February.  In addition, this total represents an 82% plunge from the 9,791 layoffs reported during February of 2014.  Over the first two months of 2015, layoffs at financial services firms are 50% lower than the total seen over the same period last year.

The improvement seen in layoffs was also seen in new hiring.  During February, financial services firms announced a healthy 2,700 new jobs to be filled, a twelve-fold increase from January’s modest 200 new jobs reported and a six-fold increase from 400 new hires announced in February of 2014.  Over the first two months of this year, new hiring has totaled 2,900 jobs – up significantly from the 529 new jobs announced during the same period in 2014.

As you can see from the above chart, announced layoffs dipped below announced new jobs during February – a development that has only taken place twice in the past year.  In addition, the chart above does show that the spikes in layoffs have gotten less pronounced in the past few years – an obvious sign that the job picture on Wall Street is improving.  Despite these trends, we should not conclude that the Wall Street jobs outlook is healthy.  Layoff announcements are an extremely volatile series, and we would not be surprised to see layoffs head significantly higher in the coming months.

Specific Layoff Announcements

Last month, Royal Bank of Scotland Group announced that it plans to eliminate more than 1,000 jobs at its U.S. trading division as part of a global restructuring of its investment bank.  Most of these jobs are expected to come from the bank’s operations in Stamford, Connecticut. The job losses are part of a wider plan for the investment bank to focus on 13 countries instead of 38.  The Financial Times reports that RBS could cut as many as 14,000 of its 18,000 jobs within the firm’s investment bank.

Bank of America announced that it is laying off 250 staff in Charlotte, 200 employees in Norfolk, and 69 workers in Jacksonville – primarily from its mortgage and technology groups. The layoffs are driven by the bank’s reduction in its portfolio of bad loans.

JPMorgan Chase also announced that it plans to lay off 163 employees from its customer service office in Jacksonville, Florida by March 30.  The bulk of these cuts are slated to come from its mortgage servicing staff as the bank responds to a reduced level of mortgage originations and lower bad loans.

While no specific number of layoffs was announced, Credit Suisse management did say last month that it plans to make hundreds of millions of Swiss francs in additional cost cuts and sharply reduce bonuses for top executives, as the Swiss bank braces for challenges presented by the strengthened franc and continues to deal with the effects of a large legal settlement.  Management explained that the cost reductions will likely involve both job cuts and moving employees out of Switzerland to lower-cost locations.

Impact on the Research Industry

So, does this pickup in Wall Street employment over the last few months mean that hiring in the research industry will improve this year?  We seriously doubt it.  In our minds there are three factors that will drive research hiring.  This includes equity commission volume, IPO volume, and regulatory developments.

As we have mentioned in the past, equity commission volume looks to be stronger during the first two months of the year than we have seen in the recent past, providing an encouraging sign to many investment banks.  However, IPO volume is down sharply so far this year after the torrid pace of new issues seen in 2014.  Lastly, one of the biggest unresolved issues for most research management is what ESMA decides to do with its MIFID II proposal regarding the use of client commissions to pay for sell-side and independent research.  We believe that whatever ESMA decides on this score, sell-side investment banks will suffer a significant reduction in revenue for their research.

Consequently, we see one positive factor (trading commissions) outweighed by two negative factors (IPO volume and regulatory developments) impacting research hiring.  In our minds, this means that the employment outlook for research analysts, sales people, and other research support staff at sell-side and independent research firms should remain subdued during 2015 – at least until one of the two negative factors discussed above turns bullish.

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Second Annual “Alpha Innovation Required” Summit A Success

March 9th, 2015

Despite the snow storm that blanketed much of the east coast last week, Franklin Templeton successfully pulled off their second annual “Alpha Innovation Required” (AIR) summit in Fort Lauderdale, Florida where almost two dozen hand-picked trading and research technology vendors presented how their products or services could help buy-side investors generate alpha.

Purpose of AIR

The second annual AIR Event was organized by Franklin Templeton’s SVP, Director of America’s Trading, David Lewis who oversaw the vetting of hundreds of financial technology firms to identify twenty-one unique providers that presented their solutions during the two-day event.

The attendees of the conference included approximately 200 senior sell-side and buy-side heads of trading desks, technologists/CTOs, Directors of Research, COOs, strategists, and other industry executives.  As the title of the event implied, the focus of these presentations was how these innovative companies could help institutional investors generate alpha from their investment process.

Keynote Speakers

Like all successful industry conferences, the 2015 AIR Summit featured a few interesting and thought-provoking key-note speakers.   The keynote speakers who presented included:

Dan Kaufman, Director of Information Innovation Office, DARPA.  In this position Mr. Kaufman is responsible for identifying and creating promising new information technologies and developing DARPA programs to exploit these advances for the benefit of the DoD.

Bob Bigman & Whitney Kassel, The Arkin Group.  Robert Bigman recently retired from Central Intelligence Agency (CIA), after serving a thirty year distinguished career. Recognized as a pioneer in the field of classified information protection, Mr. Bigman developed technical measures and procedures to manage the nation’s most sensitive secrets.  Ms. Kassel joined The Arkin Group from the Office of the Secretary of Defense, where she specialized in Pakistan policy, Special Operations and Counterterrorism, and sensitive activities.

Neal Huntington, GM Pittsburgh Pirates.   Neal Huntington was named Senior Vice President and General Manager of the Pittsburgh Pirates on September 25, 2007, thus becoming the 12th G.M. in the history of the club. In this role, he is responsible for the entire baseball operations department, which includes overseeing the Major League club and scouting and player development systems.

Innovative Vendors

Of course, the true focus of the AIR Summit was the presentations made by the twenty-one hand-picked financial technology vendors (and the small group meetings that followed).  Each of these vendors represented a few macro trends impacting the investment management industry.  The trends highlighted at the AIR event included the use of “Big Data Analytics” to generate alpha; technology advancements in the trading and research process; “Machine Learning” strategies in investments; and behavioral finance.   The vendors who presented included:

  • Airex Market
  • Blacklight from S3 Partners
  • BlueMatrix
  • Brand Loyalties
  • Cabot Research
  • Dataminr
  • EidoSearch
  • Everysk
  • IBM Research
  • ITG
  • Knowsis
  • Meetyl
  • Orbital Insight
  • RAGE Frameworks
  • Red Deer Systems
  • Sentieo
  • SMART Suite
  • TheySay Analytics
  • TickerTags

Click here for brief explanations about each of these presenting vendors.


In my opinion, the 2nd Annual AIR Summit was a big success.  As was the case last year, the conference featured some entertaining and educational key-note speakers.  I really enjoyed Neal Huntington’s discussion of transitioning a MLB team to the use of analytics as a part of their management and coaching process.  In addition, the AIR summit highlighted some pretty cool new companies and products (only 1 of the 21 vendors presented at last year’s summit).  Lastly, I thought that Franklin Templeton successfully positioned themselves as an industry thought leader by inviting unique vendors, their sell-side brokers, and a large number of their buy-side competitors to network, gain new insight, and discover potential new providers from their participation in this event.

As I concluded last year, I would recommend next year’s AIR Summit (or whenever they plan to do this again) to any professionals who make use of third-party fin-tech systems as a part of their investment or research process.  The conference was very enlightening and, in my view, could be extremely profitable as attendees were introduced to a small group of innovative and little known vendors who could help buy-side firms enhance their investment returns from a wide variety of perspectives.  From the vendors’ perspective, not only did they get to spend quality time with potential customers, but also had the opportunity to discuss potential business partnerships with other firms that served the investment management industry.  In my opinion, it was a win-win for everyone.

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86% of European Traders Say Research Payments Will Decline Under New Regulation

March 5th, 2015

TABB Group released a study indicating that two-thirds of the heads of buy side desks trading European equities expect their research payments to decline due to proposed regulations.  European firms envisage a greater impact, with 86% of firms anticipating a decline in research payments.

The TABB survey was conducted with 50 global heads of trading interviewed in January 2015.   Surveyed firms comprised 44 long-only asset management firms and seven hedge funds, managing €25.5 trillion (US$28 trillion) in assets under management.

Surprisingly, a majority of respondents claimed they had already implemented a research budgeting process.  58% of participants said they now have a budget target for research payments, and 55% anticipate switching to execution-only commissions once the target has been reached.

Not surprisingly, over 90% of participants see mandated CSAs as a potential solution to the regulatory deadlock, contrary to the UK regulator’s interpretation of pending MiFID regulation.  38% percent of UK firms and 30% of all respondents are now sitting on the sidelines unsure of the outcome the regulatory brawl over research payments.

UK regulators argue that asset managers will be able to fund research payments by passing along hard dollar research fees to clients.  However, 59% of TABB survey participants believe that their firms will be unable to increase fees to pay for research in the current competitive environment.  46% see the forced absorption of any increase in fees as having a direct negative impact on their firm.

79% of participants foresee that smaller asset managers will be at a disadvantage as a result of the proposed changes; including 75% of larger asset managers and 79% of medium sized asset managers.

As directed by UK regulators, 68% of participants are in conversations with their brokers to try to value bundled research, but 56% are dissatisfied with the progress so far.  Few on the sell side are providing the required pricing points yet.

TABB predicts that smaller European brokers are likely to suffer under proposed regulatory changes.  “A decrease in consumed research will lead to a decline in investment in research provisions, which will lead to a fall in revenue, which will in turn make the provision of research an expense few can afford.  Unattractive sectors may also suffer.  We have already witnessed the widespread closure of small-cap execution desks.  Few global investment banks will be motivated to carry out research on SME firms given the lack of profitability.”

TABB predicts that complex management of commission allocation payments will require in-depth technological solutions.  It believes that recent fintech advances might help, but “the level of disruption to the industry is yet to be determined.”

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How Discretionary Are Commission Allocations?

March 4th, 2015

Woodbine Associates, a capital markets consulting firm, released a new report claiming that US$7.5 billion of U.S. equities commission spending is discretionary.  This flies in the face of perceived wisdom that the majority of commissions are locked up to pay for research.  Woodbine’s findings argue that buy side traders feel less obligated to investment banks than Wall Street assumes.  Woodbine also expects that commission spending will flatten out over the next few years.

Woodbine’s new report, “Broker Opportunity Among Institutional Investors in the US Equity Market”, is based on an online survey of 49 senior traders at long-only asset management firms.  Woodbine said the survey sample represents approximately 20% of the $10 billion long-only U.S. equity commission wallet.

Majority of commissions are discretionary

Woodbine’s survey indicates that 75% of the estimated US$10 billion long-only commission budget is discretionary and that 62% of institutional investors with more than US$10 billion equity AUM indicate that 90% or more of order flow is discretionary.  ‘Discretionary’ means that traders believe they can send the commissions to any best execution broker they choose.

These results are counter-intuitive because other surveys have shown that as commissions have been shrinking since 2009, an increasing amount — 60% or more — of the commission pool is being allocated to pay for research.  If more than half of the commission pool is needed to pay for research, how can 75% or 90% be discretionary?  One potential answer: commission sharing agreements (CSAs).

CSAs = Discretionary?

There are two problems with the CSA solution to this puzzle, however.  The first is that in the U.S. bulge bracket investment banks do not accept payment for their proprietary research through CSAs, requiring direct allocations for their research.  In an interview Matthew Samelson, Woodbine’s CEO, indicated that the bulge banks had not relaxed this requirement.  This would mean that Woodbine’s survey is saying that only 25% of US long only commission allocations are going to pay for bank proprietary research.  We strongly doubt bank share has dropped that far.

The second problem with CSAs as the source of massive discretionary order flow is that CSAs represent only 35-40% of US equity commission volume.

Stabilizing commission budgets

Woodbine’s survey also projects a 2% increase in commission spending for long-only asset managers in 2015.  Woodbine expects commissions to remain flat through 2016.

“It is too early to tell if this increase marks a sustained reversal in the downward trend,” Samelson said. “Our data suggests we are entering period of stabilized industry budgets.”  He added that commission spending will continue to be a zero sum game. Growth will only come from taking market share from others.

Our Take

We recently spoke with the head of commission management for a major long-only asset manager who said that his portfolio managers increasingly rely on boutique research firms for their stock analysis because of deeper sector or geographic expertise.  In his view, the main value received from bulge firms is corporate access.

If this individual’s view is shared among other long-only managers, this would support Woodbine’s view that commissions are more discretionary than many sell-siders think.  However, we struggle to see how 90% or even 75% of commission allocations are discretionary.

Traders rightly have a perspective that they can trade anywhere, directing any given trade to whomever they feel is the best counter-party.  If I were to ask a bunch of senior traders what % of trades they can direct anywhere, I would probably get responses in the range of 75-90%.  However, if I were to ask senior traders what % of their total commission spending must be committed to pay for research and advisory services, I would get very different numbers.

As for the outlook for commissions, flattening is a plausible scenario.  The problem is that the buy side always overstates their projected commission spending.  The Woodbine survey’s 2% growth in 2015 could easily be 5-10% declines.  The reality is that commission spending is very hard to project accurately.  Unfortunately the longer term pressures on commissions remain: shifts in assets from active to passive, regulatory measures to unbundle commissions, declining commission costs and the rise of electronic trading.  Woodbine is correct in saying that growth will continue to be a zero sum game.

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European Lawmakers and Regulators Oppose Research Commission Ban

March 2nd, 2015

European lawmakers and regulators have waded into the brawl over a potential ban on paying for investment research with client dealing commissions.  Members of the European Parliament (MEPs) are voicing concerns over harmful effects of a ban while French regulators directly challenged UK regulators’ interpretation of the proposed language as a ban.

Bloomberg reported that Markus Ferber, an influential European Parliament lawmaker, said he’s “not entirely happy” with regulators’ proposals that would force asset managers to separate payments for research from those they make to brokers to execute trades.  Ferber is a Member of the European Parliament (MEP) representing Bavaria, Germany and Vice-Chair of the European Parliament’s Committee on Economic and Monetary Affairs, which which oversees financial regulation.

Concerns over impact on SMEs

Ferber expressed concerns about shrinking research coverage in the wake of a ban.  While he felt guidance issued in December by the European Securities and Markets Authority (ESMA) moves in “the right direction” compared with an earlier draft, the measure “could still harm the coverage certain companies receive” from researchers.    This would be “counterproductive” as the EU tries to spur investment in companies through capital markets, he said.

“When it comes to equity research, our general goal should be to make capital markets financing easier, especially for small and medium enterprises which benefit most from equity research,” Ferber said. “We should bear in mind that too strict provisions on the treatment of equity research would especially harm SMEs.”

“This topic will certainly be discussed once more in the framework of the MiFID level-two process in the weeks to come,” Ferber said, referring to the procedure that will be used to agree on the technical rules.

Concerns over feasibility

The EU must make a full impact study of the proposals, Cora van Nieuwenhuizen, a Dutch member of the parliament’s Economic and Monetary Affairs Committee, said in an interview.

It makes sense for research to be seen as an inducement given to portfolio managers, and so covered by EU rules in this area, “but whether ESMA’s is the right approach, we have some worries about that — about whether it’s practical, workable,” van Nieuwenhuizen said.

One concern is the potential administrative burden for asset managers from setting up special research accounts, she said.  Another is the potential impact on small businesses.

“It’s absolutely necessary that we have a proper impact assessment into what the effect will be on small stocks,” she said. “We don’t want investment in them to dry up completely, that would be a disaster.”

French Regulators Weigh In

French regulators have opposed a ban on research commissions ever since the UK Financial Conduct Authority (FCA) first raised the issue.  “We don’t see the ESMA technical advice as a way to completely forbid CSAs [Commission Sharing Agreements],” said Benoît de Juvigny, secretary general of the L’Autorité des Marchés Financiers (AMF), in a recent interview reported by the Wall Street Journal. “If CSAs are completely forbidden we are afraid, though we haven’t done any precise impact study, that it could increase the difficulty to finance research particularly for smaller companies where it is already difficult to find research.”

De Juvigny said the French believed the UK Financial Conduct Authority’s view that CSAs were “incompatible with the intention of ESMA’s proposals” was a misinterpretation and that a revised form of the agreements would still be allowed.

Will Dennis, head of compliance at AFME, the main trade group for Europe’s investment banks, confirmed that some European regulators would not go as far as the FCA.   “If the FCA proceeds with [a ban]there will be an unlevel playing field across Europe,” he said.

Our Take

We noted parliamentary opposition to a ban last November when Kay Swinburne, another member of the Committee on Economic and Monetary Affairs, stated that MEPs “made it very clear to ESMA that disclosure of the use of commissions is sufficient and banning of commissions should be off the table.”  Now two other MEPs on the Committee, including a Vice Chair, have expressed concerns about a ban. Nevertheless, there are sixty members of the committee including four Vice Chairs so three opponents do not necessarily speak for a majority of the committee.

Although French opposition is no surprise, but it confirms that the urgency of the debate.  The FCA made its position crystal clear last week and now opponents are marshaling their response.

We have been asked by asset managers and research providers about the probability of the outcome.  At this point, for the reasons we have articulated previously, we believe that it is probable that the final language will not ban the use of client commissions for the payment of investment research.  However, faithful readers will recall that we were originally skeptical that the FCA would ever go so far as embracing a ban.  In being wrong-footed by the FCA’s growing passion over this topic, we have developed a healthy respect for their mastery of the subject and  their success so far in steering the process in a direction they favor.  It will be a very close thing either way, and a lot of fur is going to fly before it is settled.

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