Markit Integrates Broker Vote and Commission Management

August 15th, 2014

Markit has integrated its commission management and broker voting software according to a recent article in Wall Street & Technology.  The timing of Markit’s release is aided by recent UK regulatory activity, but the longer term future for commission management is clouded by pending European regulation.

In 2011, Markit launched a commission management platform with the backing of a consortium of major investment banks.  The platform allows asset managers to reconcile their trading commissions with multiple counterparties and pay for research and brokerage services from the platform.

Markit says its commission management platform currently has 130 asset manager clients with 35 brokers using the platform.  Convergex, which acquired Cogent Consulting’s commission management platform in 2009, claims over 500 buy side clients and 144 participating brokers.

Markit’s newly integrated system allows asset managers to compare broker vote results to actual commission payments to look for brokers which are overpaid or underpaid relative to the rankings assigned as part of the vote.

The enhancement is part of larger integration plan announced when Markit hired a new manager, Tom Conigliaro, to head a newly created Trading Services group at the beginning of 2014.  Conigliaro’s plan is to integrate commission management, broker voting with trade cost analysis (TCA) and fundamental trading tools.  Next on the agenda is integrating Markit’s Calendar module, which notifies investors about conferences, events, analyst one-on-ones, and non-deal roadshows.

Markit’s goal is to create a trading dashboard with alerts such as when transactions hit a certain limit, or liquidity estimates have been breached, for example.   One such alert could be budget limits on commissions allocated to specific brokers based on the broker vote system.

The UK Financial Conduct Authority (FCA) has recently implemented regulation requiring asset managers to take steps to better manage client commissions allocated to the purchase of investment research.  Markit’s alignment of its broker voting and commission management capabilities is consistent with the recent FCA directives, which is encouraging investors to manage research-related commissions more carefully.

However, the FCA recently threw its support behind pending European regulation which would effectively ban the ability to pay for research through client commissions.  If the current draft language in MiFID II is ultimately adopted, the need for commission management tools will diminish, at least in Europe.   In the meantime, Markit continues to move forward with its integration plans.

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Layoffs Surge on Wall Street As Volumes Remain Weak

August 11th, 2014

Wall Street layoffs spiked in July as many investment banks have made cost cutting a priority due to poor market conditions including weak trading volumes, low volatility, and poor results from their fixed-income trading units.  Unfortunately, poor market conditions in July and recent regulatory uncertainty don’t seem to help the near-term employment outlook at Wall Street firms.

July Challenger, Gray & Christmas Report

According to Challenger, Gray & Christmas’ monthly Job Cuts Report released a few weeks ago week, the financial services industry announced a 76% surge in planned layoffs during July of 1,580 jobs from 897 layoffs announced in the previous month.  Despite the spike in planned layoffs in July of this year, this level was 24% lower than the number of layoffs announced in July of 2013.

Clearly, one sign that the employment picture is starting to improve is that on a year-to-date basis, Wall Street firms have announced 41% fewer layoffs in 2014, or 23,058 layoffs, compared to 38,846 job reductions announced during the same period in 2013.

Planned hiring at financial services firms also rose by 1,200 new positions in July following no new hires announced in the prior month.  Despite the July rise in new jobs announced, year-to-date hiring plans at Wall Street firms remain sluggish as 15% fewer new jobs have been announced so far in 2014 when compared to the same period in 2013.

Market Activity Sluggish in July

However, the employment outlook on Wall Street is unlikely to improve markedly in the near-term as market conditions look quite weak.  For example, a few weeks ago, Barclays CFO, Trushar Morzaria, explained that July was possibly the worst month of the year for Barclays’ investment bank.

More recently, Deutsche Bank’s banking analysts are also voicing concerns about recent market activity.  In a note released recently, Deutsche Bank analysts point out that revenue in July 2014 seems to have been weaker than is normally the case.  Fixed income currencies and commodities (FICC) revenues seem to have suffered particularly. Primary issuance of asset backed and mortgage backed securities were down 19% and 42% year-on-year respectively.  High yield and investment grade issuance were both down 14%.  FX and interest rate derivatives declined again.

Even Deutsche’s equities businesses didn’t do as well as hoped.  Deutsche points out that although IPOs were up 115% in July 2014 versus July 2013, the comparables are favorable as July 2013 was a weak month.  More worryingly, Deutsche points out that the equities capital markets pipeline has declined 26% over the past two months, which it says could prove troublesome.

Impact for the Research Industry

So, what does this mean for hiring in the research industry?  We suspect that the recent sluggishness seen in most divisions (excluding investment banking) at many Wall Street firms does not bode well for sell-side research departments.

However, the biggest concern Wall Street management is likely to be facing at the moment is the uncertainty around whether UK and European regulators are likely to ban asset managers’ use of client commissions to pay for sell-side and independent research.  It is highly unlikely that many Wall Street firms will be hiring aggressively until they see what regulators decide regarding this issue.

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Trade Groups Pan Proposed Research Commission Ban

August 7th, 2014

Comments on the proposed language in MiFID II banning research commissions have been negative, reflecting broad opposition among asset managers.  Despite this, informed sources expect little change to the proposed language in the final rules.

The European Securities and Markets Authority (ESMA), the European-wide regulatory authority whose members are the financial markets regulators in each of the 28 member states, is charged with codifying the regulatory language associated with the MiFID II laws passed by the European parliament in April 2014.   ESMA published a 500-page discussion paper in May 2014 and requested comments by August 1st.   Many of the groups commenting have made their submissions public.

The Investment Management Association (IMA), which represents the UK asset management industry,  expressed strong opposition to the ESMA draft language:

“The IMA does not support ESMA’s proposals.  Research associated with the use of dealing commissions is not an inducement.  Rather, it raises conflicts of interest, which need to be managed.  Further, ESMA’s proposals would create a muddled regime with never-ending debate about what was allowed and what was not.”

The IMA argued that the ban would invite regulatory arbitrage putting European-based asset managers at a disadvantage to asset managers based in other domiciles, such as the U.S., which are not moving to ban research commissions.

The IMA also warned of unintended side effects from the ban such as “reduced research coverage, poorer price formation, reduced liquidity in small cap stocks and raised barriers to entry for new entrants to the investment management industry.”

The IMA intends to host a conference for global regulators, investment managers and the sell-side providers of investment research to begin an evaluation of both current and alternative research models, including those where dealing commissions are no longer used.

The Managed Funds Association (MFA), a U.S. based trade association for hedge funds, also called for further study, and asked ESMA to delay any changes until a “thorough consultation and extensive study/survey” could be conducted.

The German fund association, BVI (Bundesverband Investment und Asset Management) also requested additional discussion:  “ESMA should allow for a genuine discussion on this subject before deciding on an approach which will lead to radical changes to the European Financial Market causing competitive disadvantages also to the detriment of the investors ESMA intends to protect.”

The BVI said ESMA’s proposals would have “severe consequences”, and argued the changes would lead to a decline in the number of research providers and a decrease in the information available to fund managers.   Research provided to asset managers should be viewed as a manageable conflict of interest, it added.

The AFG (Association Francaise de Gestion financière), the French fund association, reportedly said that research on smaller and medium-sized companies would suffer if ESMA’s plans were implemented.

The Swedish Investment Fund Association (SIFA) asked ESMA to exclude research from its definition of inducements because it views research is a financial service fundamentally connected to execution. It warned of unintended consequences such as increased cost for asset managers favoring larger firms with in house research facilities and creating an un-level playing field with markets outside the EU.

The Wealth Management Association (WMA), the UK trade group for smaller wealth managers, said ESMA’s proposals were “somewhat severe” and may have unintended consequences.


Despite the deluge of negative comments, those who have spoken to regulators and the European legal community believe that the ESMA language banning research commissions is likely to be adopted.  Partly this is a function of the large volume of other regulation contained in MiFID II, diverting focused attention on the inducements component.

On the other hand, the market regulators in France and Germany are rumored to be uncomfortable with extensive reform.  The Autorité des Marchés Financiers (AMF) indicated in July that it was hesitant to adopt changes that would reduce the volume of research.  It said it was concerned about the impact of a ban on French asset manager profit margins, which remain depressed after the financial crisis.  The AMF was also worried that smaller asset managers would be less able to afford research than larger managers, putting them at a competitive disadvantage.

The next step is for ESMA to publish a consultation paper which is expected between December 2014 and March 2015, which will contain the next version of inducements rules.  In the meantime, you can be sure that asset managers, investment banks, and other interested parties will be meeting with regulators to underline their concerns.    EU Member States are required to adopt MiFID II provisions by June 2016 and the rules would take effect January 2017.  How it plays out will be a matter of great interest to the research community in both Europe and elsewhere.

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Evercore Acquiring ISI To Expand Research Offering

August 4th, 2014

Rumors swirled around Wall Street last Friday afternoon that boutique investment bank Evercore Partners is planning to acquire independent research firm, ISI Group, for as much as $440 mln in an effort to grow its sales and trading business and expand its investment banking revenues.

The Deal

Evercore Partners, Inc. (EVR) a publicly traded New York based boutique investment bank, is expected to purchase International Strategy & Investment Group LLC, (ISI Group) the closely held research firm co-founded by Ed Hyman, in what would be the investment bank’s largest acquisition to-date.

People familiar with the deal say that Evercore has agreed to pay up to 8 million shares for ISI Group, valuing the research firm at between $400 mln and $440 mln, based on Evercore’s recent stock price.

Only 30% of the purchase price is expected to be paid out up front, with the remainder paid out over 5 years, based on the achievement of specific performance targets and the exact structure of the deal.

ISI is expected to be merged into Evercore’s equities business, which is 40% owned by employees, establishing a new unit called Evercore ISI Institutional Equities.  The combined unit is expected to employ about 300 staff and generate approximately $230 million in revenue.  People familiar with the deal say that approximately 15% to 20% of the employees of this group are expected to lose their jobs due to cost rationalization.

Ed Hyman, the founder and Chairman of ISI Group will stay on as chairman of the new unit for at least five years.  Evercore and ISI Group are not expected to announce this acquisition until early this week.

Strategic Rationale

Clearly, one reason for the ISI acquisition would be to help Evercore quickly expand its equity sales and trading business by leveraging the ISI brand and its well-accepted research franchise.    The addition of ISI would more than double the number of research analysts at Evercore, and increase revenues generated by the firm’s research and equity trading business by fivefold.

However, the major driver for the deal is likely to be to boost Evercore’s core investment banking business. In fact, in June, Evercore’s CFO, Robert Walsh explained that expanding their equity research offering would be a priority as it would help the firm generate more stock underwriting business.

“We’ve grown the number of companies we cover, we’ve grown the number of clients we served, and that’s been instrumental in increasing the number and the value of the underwritings that we participate in,” Walsh said, admitting: “It’s been a tough market to do that, certainly much tougher than we had envisioned when we launched it.”

About Evercore

Evercore Partners is a publicly traded New York City based boutique investment bank founded in 1995 by Wall Street deal makers Roger Altman, Austin Beutner, and David Offensend.    On January 1, 2006 Evercore Partners Inc. (EVR) went public on the NYSE by offering 3,950,000 shares at $21 per share.

Evercore operates two main businesses: Investment Banking and Investment Management. The Investment Banking division includes the firm’s Advisory services, where Evercore provides advice to clients on mergers, acquisitions, divestitures and other strategic corporate transactions, with a particular focus on advising multinational corporations and substantial private equity firms on large, complex transactions.

Evercore’s Investment Management segment focuses on Institutional Asset Management, where Evercore manages financial assets for institutional investors and provides independent fiduciary services to corporate employee benefit plans; Wealth Management, through which it provides wealth management services for high-net-worth individuals, and Private Equity, through which Evercore manages private equity funds.

During the fiscal year 2013, Evercore generated approximately $760 million in revenue and earned $104 mln in Net Income, while employing approximately 1000 staff.

About ISI Group

ISI Group, founded in 1991 by veteran Wall Street economists Ed Hyman and Nancy Lazar, is a privately held New York-based registered broker-dealer that provides macro-economic and fundamental research, sales, and trading services.  ISI sells its research products to institutional investors in the United States, Europe, Canada, Asia, Australia, and Latin America; and provides equity, program, and options trading services to these institutional customers.

Ed Hyman, 69, built his reputation as one of the top economists on Wall Street as he won Institutional Investor magazine’s annual survey in this category for more than 30 years.  Consequently, ISI’s initial business was providing macro research and portfolio strategy advice. ISI started adding fundamental stock analysts to expand the firm’s research offering about four years ago after the financial crisis prompted many of Wall Street’s largest banks to scale back on their equity research businesses.

In May, 2013 co-founder Nancy Lazar left ISI Group to form a new macro research shop, called Cornerstone Macro LP, taking with her François Trahan of Wolfe Trahan (a former ISI employee).  In addition, ISI’s highly regarded policy research team, Andy Laperriere and Roberto Perli, also left to help establish Cornerstone Macro.

ISI Group generated slightly more than $200 million in revenue in 2013 from its equity research, sales and trading business and employs approximately 230 staff.  Hyman owns approximately 75% of ISI, according to regulatory filings.

Integrity’s Take

Evercore’s purchase of ISI makes quite a bit of sense to the team at Integrity Research.  Not only will it enable Evercore to gain some scale in their equity sales and trading business (a feat that has clearly been difficult for it to accomplish on its own), but the addition of ISI will give Evercore more extensive research coverage which should help the firm win more investment banking mandates.

Also, the deal looks to be financially quite beneficial for Evercore.  The purchase of ISI for 2.0 to 2.2 times revenue when Evercore earns a multiple of close to 3.0 times revenue means they will get a $600 mln increase in market valuation for a maximum cost of $400 mln to $440 mln over 5 years.

The deal also looks like it makes a lot of sense to Ed Hyman and ISI Group as they have been positioning themselves for a sale for quite a few years.  In fact, a few years ago, ISI’s name was mentioned as a potential acquisition target for Nomura as they attempted to quickly build their equity sales and trading, and investment banking businesses here in the US.

Clearly ISI decided that it was the right time to sell the business now.  We suspect this had to do with the fact that equity commissions have slipped in the last few years, making revenue growth quite difficult for ISI.  More importantly, we think that the uncertainty the recent ESMA and FCA pronouncements have cast on the entire sell-side model of charging for research through bundled commissions probably convinced ISI management they should sell the business as soon as possible.

Of course, it remains to be seen what if anything will happen as a result of the recent FCA and ESMA reports.  In addition, it is unclear what kind of impact a change in European regulations surrounding the use of commissions to pay for research will have in the US where the bulk of Evercore’s and ISI’s sales and trading business currently resides.

This uncertainty may be one of the reasons that 70% of ISI’s purchase price is expected to be structured as an “earn out”.

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Euromoney Acquires Conference Business

July 30th, 2014

Euromoney announced that it is buying a mining conference business to expand its footprint in the commodities markets and with investors, complementary to its Metal Bulletin and Institutional Investor brands.

Euromoney is acquiring the trade and certain assets of the Mining Investment Events Division of US-based Summit Professional Networks. The principal asset being acquired is a conference on African mining, the Investing in African Mining Indaba.  It takes place every February in Cape Town, South Africa, and attracts over 7000 mining professionals.

Euromoney will pay £45.3 million (US$77 million) in cash, funded from Euromoney’s existing committed borrowing facilities.  The conference business earned an adjusted EBITDA (before allocation of Summit central costs) of £6.2 million (US$10.5 million) for the year to June 30, 2014, representing a 7.3x multiple on adjusted EBITDA.

Separately, Euromoney announced that revenues were down 6% in the second quarter, blaming sterling’s 10% appreciation against the US dollar over the last year. It said that underlying revenues which exclude the impact of currency movements and acquisitions were in line with last year.  In the announcement, Euromoney did not break out revenues for subsidiaries BCA and Ned Davis Research.

Euromoney said that challenging market conditions have continued, with the pressures on the investment banking sector, particularly fixed income trading, showing no signs of abating, more than offsetting improving conditions in the the asset management industry.

Euromoney does not expect significant improvements in revenue trends until the banking sector improves.

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Hedge Funds Capitalize on Political Intelligence: Study

July 28th, 2014

According to a recently revised academic study, U.S. hedge fund managers have clearly gained an information advantage from their connection with lobbyists, enabling them to generate excess returns.  However, this advantage may have decreased significantly after the STOCK Act was signed into law in 2012.

Background of the Study

Over the past few years, legislators have been concerned about how hedge funds get access to and trade on nonpublic information from Washington DC that they obtain from lobbyists, boutique research firms, and others dealing in “political intelligence”.

Unfortunately, the opaque nature of the hedge fund industry has made this topic very difficult to study with any rigor – that is until the publication of a recent academic study called “Capitalizing on Capitol Hill: Informed Trading by Hedge Fund Managers”. The most recent draft of this study was published on July 25, 2014 by Jiekun Huang, Assistant Professor of Finance at the University of Illinois at Urbana Champaign and Meng Gao, also from the same institution.

This study examines the thesis that U.S. hedge fund managers obtain an informational advantage through their connections with lobbyists that help them generate excess returns on their trading of stocks that are highly impacted by government policy.   Click below to download a copy of the paper:

Details of the Study

Mr. Huang and Ms. Gao used public lobbying disclosure data to identify which hedge funds had hired lobbyists.  They assumed that hedge funds that hire lobbyists do so primarily to obtain private information about ongoing or impending government actions.  They considered these funds to be “connected hedge funds”.

The authors also used lobby disclosures to determine which stocks might be most impacted by government policies by identifying the public companies that engaged most heavily in corporate lobbying.  This was based on the assumption that companies whose operations and profitability are most impacted by government policies were most likely to try and influence government actions by actively engaging in lobbying.  The authors called these “politically sensitive” stocks.

Leveraging a large dataset of hedge funds’ long-equity holdings, Huang and Gao measured whether connected hedge funds’ trading activity or performance in politically sensitive stocks were statistically different than the activity of non-connected funds when looking at their holdings of similar stocks.

The authors found evidence that, on average, connected funds’ trading volume in politically sensitive stocks account for 8.9% of their total trading volume, compared to 7.3% for non-connected funds.  They also found that connected hedge funds earned abnormal returns of 63 to 86 basis points per month on their political holdings when compared to non-connected funds, suggesting that connected hedge funds possess an informational advantage in trading politically sensitive stocks.

Impact of the STOCK Act

The Stop Trading on Congressional Knowledge (STOCK) Act, signed into law in April 2012, has established a clear duty of trust and confidence for government officials, thus exposing hedge funds that trade on private political information to potential insider trading liability.  Prior to passage of this act it was unclear what liability hedge funds had when trading on private information obtained from U.S. government employees.

Mr. Huang and Ms. Gao analyzed whether the passage of the STOCK Act had any impact on hedge funds’ performance in trading politically sensitive stocks.  Consequently, they ran a test of the performance of connected hedge funds trading in politically sensitive stocks for the twelve months before and the 12 months after the enactment of the STOCK Act.

What the authors discovered was that connected hedge funds earned abnormal returns of between 59 and 96 basis points per month during the twelve months before the STOCK Act was passed.  However, during the 12 months after the enactment of the STOCK Act, connected hedge funds generated statistically insignificant returns in their trading of politically sensitive stocks.

In other words, introducing a potential legal liability associated with trading on nonpublic political information due to passing the STOCK Act all but eliminated the benefits that hedge funds derived from obtaining this type of information from lobbyists.

When asked whether the study proved that Washington had eliminated the profit that hedge funds could generate from private political information, Professor Huang said, “That is an extremely tricky question.  Based on our analysis, we conclude that connected hedge funds’ informational advantages in political stocks decreased significantly after the implementation of the STOCK Act.  However, our tests do not suggest that the Act eliminated the profits from trading on private political information.  The fact that we do not observe significant political outperformance for these funds after the STOCK Act may be because the Act truly eliminated the abnormal profits or because our tests are not powerful enough to detect such profits.  More analysis needs to be done before we can conclude if additional legislative action needs to be taken to eliminate the informational advantage hedge funds gain from their interaction with lobbyists.”

Integrity’s View of This Study

In our view, this study was hampered by a few factors, including data limitations.  Professor Huang was cognizant of this issue when he commented, “Both the political intelligence industry and the hedge fund industry are very opaque, which makes testing our thesis a challenge.  We do not directly observe the information flow from lobbyists to hedge funds, nor do we observe hedge funds’ detailed transactions that are motivated by private political information.  To obtain such detailed data, we would need to wiretap the communication between hedge fund managers and lobbyists like law enforcement does.”

Consequently, Huang and Gao relied on public disclosure of lobbying firms and used disclosed quarterly holdings of hedge funds.  Because of a lack of data, they were not able to examine hedge funds’ use of independent policy research firms or investment banks that provide them with information or analysis on government policy developments.  They also did not have good data on hedge funds short positions during the study period, because hedge funds are not required to disclose such information.

In addition, Huang and Gao relied on lobby disclosures to identify hedge funds that were obtaining private political information from lobbyists.  However, lobbyists are only required to register an engagement under the LDA if they are specifically hired to try and influence government decisions on behalf of their clients.  If a lobbyist concludes that their engagement with a hedge fund client does not qualify as lobbying (they are not trying to influence government decisions), then they may choose not to disclose this under the LDA.  As a result, current LDA disclosures could significantly under estimate the instances when hedge funds hire lobbyists to provide them with private political information.

Lastly, Huang and Gao analyzed the impact of the STOCK Act over the first 12 months after it was passed.  Could this impact have declined over time as hedge funds became more confident that regulators would not use it as a basis to try and charge hedge funds for insider trading?  Of course, this issue could now be moot as the SEC is now in the midst of investigating up to 44 hedge funds for trading on nonpublic government information provided by independent research firm Height Securities.

Despite these issues, the team at Integrity Research felt that the recent study produced by Mr. Huang and Ms. Gao is an extremely unique and insightful one as it is the first time that anyone has attempted to rigorously analyze the benefits hedge funds obtain from hiring lobbyists to provide private information about potential government policy decisions.  This study is also important in helping the public better understand how a piece of government legislation like the STOCK Act might have actually impacted the benefits that hedge funds derive from their relationship with lobbyists.

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Proposed Ban on Research Commissions Generates Backlash

July 23rd, 2014

The aggressive UK Financial Conduct Authority (FCA) call for a ban on research commissions has generated heated reactions, even in the insular US market.  There is skepticism that other European regulators support the FCA’s position, and the regulatory battle lines are now moving to the continent.  Independents are wary of the fallout from a ban.

Two weeks ago, the FCA stunned industry observers by releasing a discussion paper supporting an elimination of asset managers’ license to pay for research with client commissions.   The FCA’s extreme position was precipitated by a review it conducted of current market practices and also by its view that the European Markets in Financial Instruments Directive (MiFID) reform was headed in the same direction.  The FCA concluded that MiFID II would effectively ban research commissions and that this would be a net positive.

Not so fast

However, many are taking exception to the FCA’s interpretation of MiFID II.  First, there is a view that the inducements provision in MiFID II was originally intended to address inducements given to retail financial advisors as incentives to recommend specific securities or funds.  The argument is that extending the inducements language to reform the institutional market was not contemplated in the original regulation.

Further, the market regulators in France and Germany are rumored to be uncomfortable with the extensive reform embodied in the FCA’s position.  We spoke with sources in Paris who attended a conference sponsored by FinFees, a French consulting firm, AlphaValue, an independent research firm, and ITG on June 24th, during which the French regulators presented their perspective.

At the conference, the Autorité des Marchés Financiers (AMF) indicated that it favored more commission transparency, and has been a strong supporter of commission sharing arrangements (CSAs).  However, the AMF seemed hesitant to adopt changes that would reduce the volume of research.  It would be concerned with the impact of a ban on French asset manager profit margins, which remain depressed after the financial crisis.  The AMF was also worried that smaller asset managers would be less able to afford research than larger managers, putting them at a competitive disadvantage.

It appears that the FCA has some lobbying to do with their regulatory colleagues, but then again, the arguments assembled in its discussion paper suggest that it was aware of continental concerns and has sought to address them.

US reactions

We have been surprised by reactions from US asset managers.  A meeting we had last week with a mid-sized US asset manager opened with a thirty-minute discourse on the shortfalls of the FCA position.  We were told that the head of US sales for a major bank fielded a dozen calls from US managers in the first few days after the FCA announcement.  US asset managers are paying attention, and not liking what they are seeing.

Not that we expected any movement from the US Securities and Exchange Commission (SEC) on this issue anyway.  The likelihood of US reform is so negligible as to be non-existent.  A repeal of Section 28(e) of the Exchange Act would take an act of Congress.  This would require a groundswell of negative sentiment to overcome the political influence wielded by the banks and asset managers.

Independent worries

Independent research providers are tantalized by the land of milk and honey envisioned by the FCA, where all research is explicitly priced and there is a more level playing field with the investment banks.  However, independents worry they will expire in the wilderness between here and the Promised Land.  We have already seen independents lose market share to banks when commissions fell 40% after the financial crisis, as asset managers shifted commissions to protect their largest relationships.

Banks are able to cross-subsidize research with their corporate finance business, giving them more staying power than independents during the financial dislocations following a ban.  Independents are concerned that the exemption of broadly distributed research from the inducements language will translate into a free pass for bank research.

Next steps

The deadline for comments on the MiFID II draft language is August 1st and there is expected to be a deluge of responses.  Reportedly the volume of responses is a factor in determining any revisions to the language.  A subsequent consultation paper is expected to be published between December 2014 and March 2015, which will contain the next version of inducements rules.  EU Member States are required to adopt MiFID II provisions by June 2016 and the rules would take effect January 2017.

In the meantime, banks are said to be aggressively lobbying European regulators to water down the inducements provision, and to oppose the FCA position.

Our take

We had assumed that the draft MiFID II language reflected a consensus among European regulators, but that does not appear to be the case.  We’ve also been surprised by the depth of US reaction.  It appears there will be a large and highly mobilized global backlash to the FCA position.

The outcome will now be a function of European politicking.  The FCA decided that its best course would be to lay its cards on the table with a thorough 59-page paper outlining its views.  The fact that it went public suggests that it may not have a strong hand to play in negotiations with its European counterparts.  Perhaps the FCA hoped for a groundswell of public support.  Whatever the goal, the FCA’s paper has had the perverse effect of galvanizing industry opposition.

The FCA bombshell might at first seem a political miscalculation, serving to frighten both friends and foes to reform.  In reality, the FCA is in a no-lose position.  The firestorm has ignited deep industry debate, even on this side of the pond.  Even if MiFID II does not ultimately ban research commissions, it will have sensitized the industry and the FCA’s regulatory colleagues to the issues surrounding research commissions.  At a minimum, the net result will be a far tighter regulatory regime than existed a year ago.

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Washington Insider Trading Probe Could Become Biggest Ever

July 21st, 2014

The SEC’s current investigation into potential illegal tipping on Capitol Hill has ballooned into one of the largest insider trading cases in history as regulators are now probing whether as many as 44 hedge funds engaged in insider trading based on the information, according to recently released court documents.

Possible Illegal Government Tipping

Initially, regulators were focused on whether a congressional staffer, Brian Sutter, illegally passed on material nonpublic information about an upcoming Medicare rate change which led to a huge spike in the share prices of several healthcare stocks, including Aetna, Humana, UnitedHealth Group, and WellCare Health Plans.

According to court documents, at around 3 p.m. on April 1st 2013, Sutter called a lobbyist from Greenberg Traurig, where he allegedly discussed the upcoming Medicare rate changes.

The lobbyist then purportedly passed on this information to an analyst at Height Analytics, an independent policy oriented research firm based in Washington DC.  The analyst then sent a note to his buy-side clients ahead of the official government announcement that Medicare would increase its reimbursements to some companies.

Thus far Sutter, and the House Ways and Means Committee, have fought the SEC’s subpoenaed for information regarding this investigation, arguing that congressional staff members are “absolutely immune” from having to comply with subpoenas from a federal regulator in an insider-trading probe.

The SEC, on the other hand, argues that Sutter’s action directly violates the 2012 STOCK Act passed by Congress that bars lawmakers and their staff from disclosing confidential nonpublic information about government matters that could move stock prices.

Investigation Turns To Hedge Funds

However, now the SEC has turned its attention to Height Analytics’ hedge fund clients who allegedly traded on the early notice of the Medicare reimbursement change.

In a July 16 declaration letter to the court, the SEC’s senior associate regional director for the New York region, Sanjay Wadhwa said that the investigation is now focused on “some of the largest hedge funds and asset management advisers in the nation.”  Of the 44 hedge funds that are now under investigation in this matter, 25 are based in New York, one in Washington, and the others in California, Connecticut, Illinois and Massachusetts, among other states.

Although the SEC did not identify the specific hedge funds under investigation in court documents, the Wall Street Journal previously reported that Viking Global Investors and Point72 Asset Management (formerly known as SAC Capital Advisors) were two funds which traded ahead of the official government announcement on the Medicare reimbursement change on the hope that health insurance company stock prices would rise.

If government regulators were to pursue all of Height Analytics’ 44 hedge fund clients who are accused of trading on this inside information, the scope of the case would easily become the largest insider trading case in history.

Difficulties for the Regulators

While this insider trading case is an extremely high profile one, many market participants say that it is fraught with difficulties for the SEC and will not be an easy one to win on a number of grounds.

The first issue that regulators need to address is whether they can prevail in their suit against Brian Sutter and Congress, forcing them to provide the information requested by the SEC in its subpoena.  This is the first time that regulators have used the 2012 STOCK Act to bring a suit directly against Congress.

However, maybe even more problematic for the SEC is whether they can successfully win an insider-trading case where investors traded on information which they did not clearly know where that information originated.

Legal experts claim that in order to violate insider-trading rules an investor must either know they are trading on material nonpublic information, or it must be proven that the investor acted recklessly in assuming that the information they based their trades on was obtained legally.

Ultimately the SEC’s case will hinge on whether the hedge funds should have known that the information in Height Analytics’ research note was an illegal stock tip rather than the result of on the ground research and a solid analytical conclusion.

In our minds, this case will clearly establish a number of important legal precedents for policy-oriented research, and we will have to wait and see how it progresses.

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Equity Revenues Down in Second Quarter

July 17th, 2014

Financial reporting from major investment banks is reflecting the worsened equities market conditions in the second quarter.  US equity market volumes were down 12.9% in the second quarter, and bulge bracket banks are reporting declines in equity market revenues for the quarter.  For the five bulge banks reporting to date, equity revenues were down 5% in the second quarter.

Bank of America cited low volatility which depressed secondary market volumes and reduced client activity.  Goldman said that lower volumes were particularly pronounced in the U.S. and Asia.  JP Morgan blamed lower equity derivatives revenue.

Equities revenues for Bank of America (-12%), Citi (-15%) and JP Morgan (-10%) declined in line with US equity volumes.  Morgan Stanley (+4%) and Goldman Sachs (+1%) bucked the trend with offsetting increases in their prime brokerage businesses.  Morgan Stanley said that “ongoing strength in prime brokerage [was] offset by lower revenues in derivatives due to declines in client volumes and volatility.”

Goldman Sachs, which reports more detail on its equity business, showed that its prime brokerage business was up 6% and market making was up 16%, cancelling out a 9% decline in its cash equities commission revenues.

Bulge firms still to report: Barclays, Credit Suisse, Deutsche Bank and UBS.

Separately, U.S. regional broker FBR & Co. said its cash equities revenue increased 2.7% quarter-over-quarter, marking the third consecutive quarterly increase in equities revenue.

Our Take

An upbeat first quarter fanned hopes that last year’s improved environment would continue for 2014.  The second quarter damped optimism, especially since all else being equal seasonality tends to suppress activity in the third and fourth quarters.  Nevertheless, current levels remain higher than the lows of 2011-2 supporting the view that the overall trend has stabilized.

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UK Regulator Supports Ban on Research Commissions

July 14th, 2014

In a dramatic move, the UK Financial Conduct Authority (FCA) has called for sweeping reform of research commissions, eliminating the ability of asset managers to pay for research with client commissions.  The aggressiveness of the UK regulator caught the industry off guard even though the FCA has strongly signaled its concerns since last October.  The FCA’s position increases the likelihood that major reforms will be implemented in Europe through MiFID II.

The FCA released a 59-page discussion paper detailing the results of its recent thematic review of client commissions, which in large part has led to a hardening of its position.  The paper, which is a must-read for anyone involved in the research industry irrespective of their domicile, articulates the regulator’s reasons for advocating major reform and its assessment of the impacts of reform.  We will review the paper in this and subsequent articles.

Supervisory review

From November 2013 to February 2014, the FCA conducted a thematic supervisory review of 30 firms including 17 investment managers and 13 brokers.  The results were not positive.  The FCA acknowledged that many of the investment firms had made improvements in their procurement of research since the FCA wrote a ‘Dear CEO’ letter to asset managers in November 2012 calling attention to shortcomings.  However, the FCA found only two firms operating at the level the FCA expected, and these were the same two firms that the FCA had originally held out as models in 2012.

The FCA found that for 11 of the investment management firms, the amount paid for research remained linked to trading volumes because the firms did not have research budgets or caps on research spend. Even more blatantly, one large firm was using dealing commission to pay for market data services in full, contrary to guidelines established in 2006 and updated this past May.

The review also increased the FCA’s understanding of the current commission regime, and it did not like what it found.  Because the majority of asset managers link research payments to trading volumes, the FCA was troubled by the fact that research payments fluctuated with the level of trading irrespective of the value of research.  Worse, asset managers were often paying for research they did not want or use.

Many asset managers were not using Commission Sharing Agreements (CSAs) which help to separate execution from research.  And while the FCA considers CSAs as current best practice, it recognized that CSAs have limitations in providing transparency and a competitive market.

The FCA also took a dim view of most broker vote practices since most broker votes do not directly assess the monetary value of the research received.

Call for reform

Both the UK Investment Management Association and the CFA Society UK suggested additional disclosure as a solution to the conflicts inherent in the current regime.  The FCA dismisses disclosure as an effective remedy, in part because disclosure was the main impetus around the regime imposed by the FCA’s predecessor in 2006, and yet it was clear that the intended recipients of the disclosure, the clients of the asset managers, were not paying much attention to the disclosures.

Ultimately, the supervisory review has led the FCA to discount the value of incremental reform, preferring deeper structural change:

“Overall, we conclude that unbundling research from dealing commissions would be the most effective option to address the continued impact of the conflicts of interest created for investment managers by the use of a transaction cost to fund external research. We believe it would drive more efficient price formation and competition in the supply of research, removing the current opacity in the market.”

The FCA’s stance on reform is not just the result of its recent supervisory review, but also reflects the parallel progress of European reform through the Markets in Financial Instruments Directive (MiFID).


While the FCA has been focusing on commissions, the second generation of MiFID has been grinding slowly through Brussels.  MiFID II will prevent portfolio managers from receiving any third party inducements, with a limited exception for ‘minor non-monetary benefits.’  Inducements include receiving research in return for client commissions, effectively banning research commissions.  The proposed language is sufficiently strict to lead the FCA to conclude that an investment manager’s ability to receive research from brokers or other third parties in return for dealing commissions will be significantly restricted.

The FCA views MiFID II as a window of opportunity for European-wide reform of commissions.  This has two benefits for the FCA.  First, it would make UK reform less of an outlier if all of Europe were under the same regime.  Second, it takes some of the industry heat off the FCA since reform would be coming from the EU not the UK.

The reality is that the FCA remains a bellwether for financial regulation in Europe, despite the UK’s diminished status within the EU.  The FCA’s strong stance on reform increases the likelihood that MiFID II will institute commission reform.

Further, the FCA outlines in its discussion paper more thorough reform than is currently implied in the draft MiFID II language, and we suspect it will be lobbying its European regulatory colleagues for the most stringent interpretation.

Why the hard line?

Though gloved in velvet, we now know that the FCA has an iron fist on this issue.  Like many in the industry, we were startled when FCA Chief Martin Wheatley passionately attacked research commissions last October.  However, we reasoned—wrongly—that concerns for UK industry competitiveness would ultimately dissuade the regulator.  After the FCA published the final rules in May of this year, the industry assumed that compliance with the new guidelines would forestall any more drastic measures.

What changed?   Two factors hardened the FCA’s position.  First was the thematic review, which convinced the FCA that no amount of regulatory reform could counteract the economic disincentives inherent in the current commission regime.  Second is MiFID II, which is heading in a hardline direction.  The FCA decided that rather than trying to steer the MiFID II toward a more moderate outcome, it would throw its weight behind making MiFID II the death knell for research commissions.


Because the FCA is linking reform to MiFID II, it is not proposing at this point to unilaterally implement a research commission ban in the UK.  Its discussion paper is meant to elicit feedback which will inform its participation in the MiFID II process.  The FCA requests comments on its position by October 10, 2014, and suggests that interested parties also submit comments to the regulatory bodies involved with the implementation of MiFID II.

The FCA expects the final MiFID II language to be finalized in late 2014 or early 2015.  Any reform implemented under MiFID II would be implemented by 2017.

Our take

The FCA’s passionate commitment to commission reform will have major implications not only in Europe, but in the U.S. and Asia.  The FCA will not only be lobbying its European regulatory counterparts as part of the MiFID II process, but also its other regulatory counterparts outside of Europe.

We deeply doubt that the U.S. Securities and Exchange Commission (SEC) will muster enthusiasm for the level of reform the FCA is advocating.  In part this reflects the fact that U.S. reform would require an act of Congress.

Nevertheless, as the FCA points out, globally active investment managers may voluntarily move to adopt European standards which would have a knock on effect for international suppliers of execution and research services.  At the very least, global managers would need the ability to implement European standards as they apply to European funds managed.

No one seeing the FCA’s recent success in banning commission payments for corporate access will dismiss the seriousness of its purpose, nor its potentially far-reaching impacts.

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