New TowerGroup Research Finds “Unbundling” of Brokerage Services May Lead to a 25 Percent Reduction of Broker-Dealers by 2012.
Still reeling under regulators’ 2003 Global Research Analyst Settlement, which cut the knot between investment banking and sell-side research, the research business is now facing serious threat of change again – as new commission management arrangements alter the way investment managers compensate research providers.
New research from TowerGroup finds that commission management is at the center of the changing relationship between buy-side and sell-side firms. It also finds that sell-side research is under serious threat from three sources: the buy-side's bolstering its own research capability; growth of alternate and independent research providers; and the popularity of automated research tools.
Recent directives from the Securities and Exchange Commission in the United States and the Financial Services Authority in the United Kingdom have further clarified soft dollar rules and outlined strict disclosure requirements. As a result, commission sharing arrangements (CSAs) and client commission arrangements (CCAs) – both easy ways to implement soft dollars – have become popular among investment managers in the last two years and will continue to be aggressively adopted. TowerGroup believes that the adoption of these new programs will lead to an “unbundling” of agency brokerage services, with profound implications for all players in the business. This unbundling will threaten the agency brokerage model, which may lead to a contraction in the number of broker-dealers worldwide by 25% between now and 2012.
“Buy-side compensation for agency brokerage services has long been a major issue in the global securities industry,” said Dushyant Shahrawat, research director of the Securities & Capital Markets Practice at TowerGroup. “For as long as soft dollars have been used – and SEC Rule 28(e) has been in existence – there have been discussions about their effectiveness as a payment mechanism, conflicts of interest inherent in their usage, and their often inappropriate use at the expense of end investors.”
Shahrawat notes that these new commission payment mechanisms will dramatically change the investment research market. “The unbundling of agency brokerage services will expose the current overcapacity in investment research, resulting in marginal providers being sidelined, and even in some prominent brokers exiting the research business.” he said.
TowerGroup believes five major factors affecting the brokerage business provide a backdrop for what is happening relative to new commission payments programs:
• Changing regulations driven by the SEC and the Financial Services Authority
• Changing economics of agency brokerages
• Pressure on the buy side from clients, pension fund investors, and consultants to provide greater clarity on best execution and use of “client brokerage”
• Increasing sophistication of investment mangers, and their interest in better understanding the value provided by brokers whether for execution, research, or capital commitment
• Growth of hedge funds and the extent to which they have begun consuming sell-side research and driving sell-side commissions
“The unbundling process could take two to four years,” added Shahrawat. “Ultimately, the severance of the close tie between execution and research will allow portfolio managers to make research decisions without worrying about execution, and allow traders to direct trades toward the best-execution brokers without worrying about research.”
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