Time for the unbundling

IFR Review of the Year 2014
14 min read

Equities sales and trading is yet another area of European banking in the midst of upheaval. Regulators want banks to be more open with the way they price equity services, including research.

Both regulation and the desire to cut costs have encouraged banks to review their equities businesses. But regulation has lent the issue extra urgency. In July, the European Securities and Markets Association published a consultation paper hinting that MiFID II (the latest set of rules that will govern trading in the EU) will force banks in Europe to unbundle their equities offering and charge separately for services, such as equities research, that they offer clients.

“It is important that members, users and participants should face sufficiently granular tariffs that enable them to access and pay for only those services they need,” said ESMA in its consultation paper. “In particular, it should be possible to pay for trade data services without having to pay for other services that may not be wanted.”

Typically with regulatory reform, the only certainty is that change is coming. Exactly what that change will entail remains unclear. The paper met with considerable resistance in consultation and is expected to see significant modifications before the next draft is published in coming months. Regulators are currently working towards a timetable that will see MiFID II rules in force from January 1 2017, though as ever there is scope for further delays.

“We disagree with some of ESMA’s proposals and believe the current regulations, which highlight the distinction between trading commissions and investment advisory fees, are sufficient if they are enforced properly,” said Ian Burn, head of cash equity at Natixis.

“The key to good regulation is transparency,” he added. “Banks and asset managers need to show clients what they are spending their money on – whether that is on the trading and execution side, or advisory. Indeed, this is what we, the regulators and clients want.”

Complicating matters is the usual problem of inconsistency between the regulatory approaches in Europe and the US, and between the UK – where the Financial Conduct Authority has already forged ahead with its own version of the changes – and Europe. That may not only be a headache for banks.

“It isn’t clear what impact geographical differences in regulatory approach will have on the buyside,” said Peter McGahan, deputy head of global equities at SG. “There is little sign of the US looking at similar regulation and Europe has also been lagging behind the UK. We will have to see what ESMA finally brings in for the MiFID ll reforms in 2017. An unintended consequence could be to put the UK asset management community at a competitive disadvantage.”

As long as Europe does not go to the extreme end of its proposals, bankers expect this to be manageable for them and their clients. But if regulations stipulate that research be charged in a very specific way, it could end up creating logistical challenges for both sellside and buyside institutions. In the worst case scenario bankers fear it could encourage US buyside institutions to repatriate their European investment operations to the US.

Not just MiFID

At the same time, clients themselves are considering their relationships. The increasing popularity of ETFs, for example, has reduced the demand for services such as equity research. All this has encouraged banks to look at how they should price execution for their clients – and forced a rethink of the entire business.

“Margins have been getting tighter for the sellside for a few years, even before the impact of further unbundling, and the whole community has been looking at ways to reverse the falling profitability in cash equities in particular,” said McGahan.

This includes, for example, looking at where they have teams in different locations covering the same things. “Research is an obvious place to look for cost optimisation and changing regulation simply emphasises the need to make changes,” said McGahan.

The unbundling of the equities offering into its component parts is going to shine a light on each individual business and force banks to justify their spending. But it also in theory opens up very specific services to competition from smaller niche banks and non-bank players such as technology companies, trading platforms or data providers.

Scale versus service

The big players appear to be relaxed about the prospect of increased competition on this territory. They argue that they have the global scale and the resources that smaller competitors can’t match. “The equity business has become more of an infrastructure and scale business than ever before,” said Mike Stewart, global head of equities at UBS.

It is increasingly difficult to provide a niche offering, said Stewart. “The buyside has seen regional active mandates replaced by global funds, passive product and total return mandates, for which you need global critical mass in research, execution and risk management capabilities on the sellside,” he said. “If you have a UK-only or Europe-only research and trading offering, that is not enough to deal with a client-base that now largely manages global businesses and investment products.”

However, those outside the top banks point to their own advantages.

“Scale is not equal to quality,” said Rob Buller, global head of account management at Kepler Cheuvreux. “We hear a lot of complaints that the quality of service at the bulge-bracket banks has declined in recent years as they restructure their businesses and lay off staff. A lot of the senior analysts at these banks have left and been replaced by less experienced junior analysts.”

Buller believes clients are spending less money with the investment banks and more with mid-sized brokers and boutiques that have more specific sector or country knowledge. Others operating in that segment agree.

“In the last 15 years, the percentage of commissions going to the top-tier banks has grown to a very high level. However, in the last 18 months we have seen the share increasing for those in the next tier down – the six to 20 top brokers,” said Burn of Natixis.

“Institutional clients are becoming more conscious of what they spend and are looking to get the best value they can get. That in some cases means paying less money in aggregate to a wider group of brokers for their key expertise in certain sectors or geographies.

Indeed, there is evidence that many banks are concluding that scale isn’t everything. In order to avoid spreading themselves too thinly, many are scaling back or exiting entirely non-core businesses, sectors or locations – tacit acknowledgement that there are limits to the number of banks that can pursue a truly global strategy.

In research, this has opened the door for independent providers such as Kepler Cheuvreux, which have capitalised as banks have stepped back. Kepler acquired the equity brokerage business of Gruppo Banca Leonardo in 2011 and entered a strategic alliance with UniCredit the same year to provide the research and distribution platform to support its ECM business.

In 2013, Kepler also acquired Credit Agricole Cheuvreux, from which time it provided the same service to Credit Agricole as it already did for UniCredit.

“It is very expensive for banks to manage their own research and distribution unless they have an unassailable market share,” said Buller. “The very top tier of banks won’t exit the business but everyone outside it will be considering their options.”

Where some are outsourcing, others will probably negotiate joint ventures to share costs and maximise coverage. Others will continue to run their own research business but will be more focused in their coverage. Natixis is exiting sectors in which it has no competitive advantage, such as mining research, and investing more in those in which it does, such as pharmaceuticals and consumer goods.

Where UniCredit and Credit Agricole decided to outsource research, Natixis has gone the other way, redoubling its commitment to this business but looking to scale down on the trading side.

“Natixis wants to focus on high touch, solutions-orientated business such as research and advisory and will continue to trade actively for clients, but we are considering outsourcing some of our low touch electronic execution so we can have the most competitive offering to [offer] our clients,” said Burn.

Too much of a good thing

Of particular concern to many is the torrent of research in the market, some of it of questionable value. Regulators believe it is only by forcing banks to price it appropriately that the number of reports can be brought down to a more manageable level.

Even banks agree that the deluge of reports generated every time a stock reports results is excessive, offering little of value to buyside clients. But one equities chief at a large US bank said that the regulators have themselves to blame.

“There is an issue of oversupply but to some extent this is a problem created by regulators themselves,” he said. “If we tweak our numbers even a tiny amount, we are required to publish a note about it despite the fact that nobody really wants that research. That is responsible for a large amount of the noise. For the FCA to say in one breath that there is too much research but there should be increased competition is absurd.”

Others concede that, although there is a problem with the quantity of supply, that does not mean quality has been compromised.

“High volumes of maintenance research, which flood fund managers’ inboxes, are in some respects easy for analysts to produce if they know their stocks very well and have done the work,” said Burn. “One person’s maintenance is another person’s update on a key idea.”

He conceded that banks and brokers need to look at the volume of research they put out and how it’s presented and delivered. “But if the underlying quality is there, and it certainly is at Natixis, then we want to continue to update our clients about themes that are relevant to our core ideas,” Burn added.

It is also difficult to pinpoint which research is or is not valuable.

“If you asked any one of our clients they would probably say only 25% of our research is interesting but every client would identify a different 25%,” said the equities chief of the US bank. “We analyse the readership stats, we know what people are reading and what isn’t being read, whether it is on certain subjects or by certain analysts, and we are always looking to make sure what we put out is interesting. But 99% of what we put out is widely read and valued by someone.”

Forcing clients to pay for research will determine exactly how valued it is, but it is still far from clear what the appropriate pricing model will be. Banks say they are not in a position to make any decisions about pricing models until the new rules themselves have been finalised.

There are a number of possible approaches. Banks could charge on a pay-per-view or full subscription basis, or at an hourly rate for the analysts’ time, among other options. It may be that different banks choose different approaches, with a clear winner emerging over time or multiple pricing models proving viable for different businesses.

Certainly, there is specific value around face time with analysts. For written reports, bankers say it isn’t practical to charge clients precisely for the research they use – though that may change over time. But it may be that banks can track aggregate use of research over a given period, feed that information into a pricing model and then charge clients a certain amount for that use from their CSA (commission sharing arrangement) at the end of that period.

“Big asset managers will need some level of packaging, there will probably be some kind of tiered service,” said McGahan. “Pricing may become more granular over time but providing some kind of shopping list for research across all clients will be hugely challenging. You always have to invest time in covering smaller companies and in your own future talent, and to some extent your more profitable business will always have to help pay for that.”

In part because of the oversupply, it is very much a buyer’s market, and it is the buyside that will determine how banks end up charging for research. But it is also an opportunity for the buyside to drive down their own expenditure on research.

“Buyside spending on research is going to shrink over time, banks need to be prepared for that,” said McGahan.

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Time for the great unbundling