Wall Street no fan of greater transparency
It is pushing back any US attempt to enforce European rules on investment research
corrosive custom forced on investors is finally getting the axe under new regulations in Europe. Too bad some on Wall Street are working overtime to ensure that US investors don’t get the same deal.
The rule change governs how investors pay for brokerage-firm research. This may seem like a mundane administrative matter, but given the conflicts embedded in the process, it is not. Currently, big institutional investors pay indirectly for research services provided by brokerage firms; they include analyses on industries and companies as well as access to top corporate executives in events sponsored by the Wall Street banks.
Rather than pay cash for these services, the investors send trades to the firms, generating commissions. Exchanging commissions on these trades for research — known in the vernacular as soft-dollar arrangements — has been the way of the world for decades. But pension funds and other institutions have chafed under the deals because they can harm investors while benefiting Wall Street.
Functions separated
After more than a decade of regulatory inquiry into these commission-sharing arrangements, European regulators didn’t like what they saw. So they decided to separate the two functions, requiring payments in hard dollars for both research and trade executions. The new rules go into effect in January as part of an effort in Europe to improve markets after the 2008 financial crisis. Investor protection is central to the new regulations, known as the Markets in Financial Instruments Directive, or MiFID. As the regulators and others have noted, there are several problems with the research-for-commissions set-up.
One is a lack of transparency — bundling research costs with trading makes it difficult for investors to see what they are paying. Another downside: Exchanging trading commissions for research binds an investor to a firm regardless of how well or poorly it executes an investor’s trades.
Tying trading to research also hurts smaller research outfits that may be producing outstanding analyses but that don’t have the trade-execution capacity needed to receive soft-dollar payments. The inverse is also true: Brokerage firms that produce junk research — non-stop “buy” recommendations, for example — are perversely rewarded by the soft-dollar payments they receive on trades.
Howell E. Jackson, a professor at Harvard Law School and an expert in financial regulation, thinks the unbundling of trading and research costs would be a boon to investors because of the sunlight it would bring to the financial markets. Under the European rule, Jackson said, “consumers can see how much of their commissions are going to research.”
The rule “also makes it easier to monitor best execution,” and it could encourage the creation of high-quality independent research shops, he said.
But greater transparency is not something Wall Street generally wishes for, which might explain why some firms are opposing an unbundling of research and trading costs.
Another reason Wall Street prefers the status quo on research and trading is the information edge it provides.
Big investor orders represent crucial information for brokerage firms, which can generate rich profits by trading around the transactions. If investors start sending orders to firms based only on superior execution, the big broker-dealers could lose that information source.
Under the European system, research and trading are likely to improve, investors say. That’s because they’ll be able to reward firms that produce meaningful investment analysis as well as those that generate excellence and efficiency in trade executions. Investors’ costs will also come down because they will no longer be at risk of paying up for bad executions or mediocre research.
“Separately shopping for research and trading will significantly reduce investors’ costs,” said Tyler Gellasch, executive director of the Healthy Markets Association. “That directly translates to higher returns and more money for retirees and college savings funds.”
Even as Europe moves to a new and fairer regime, some on Wall Street are quietly urging the Securities and Exchange Commission to maintain the bundling of research and trading in US markets. Among them is Goldman Sachs, which has told some of its big investor clients that it opposes separating research from trading.
The main argument offered against separating research and trading is that brokerdealers that publish analysts’ reports would have to register as investment advisers, subjecting them to an additional regulatory burden.
Kenneth E. Bentsen Jr., chief executive of the Securities Industry and Financial Markets Association, a top lobbying group, is leading the charge. In a statement, he said: “Our efforts reflect the fact that research plays a fundamental role in our capital markets and in the capital formation process, and the continued availability of research is essential to the vibrancy and health of our markets. Current US law prohibits broker-dealers from providing unbundled research unless they register as an investment adviser, which could have an unintended but harmful effect on the markets and investors.”
But many major firms are already registered as investment advisers. So all they would have to do to resolve the issue is move their research operations into their investment advisory units. Not all brokerage firms are against the unbundling of research and trading.
A spokeswoman for Merrill Lynch confirmed what some of its clients have told me — that the firm is willing to receive cash payments for research. This is good news to the Council of Institutional Investors, an association of more than 125 public and private pension plans, endowments and foundations.
Jeff Mahoney, its general counsel, recently wrote a letter to Jay Clayton, the chairman of the SEC, asking that the agency allow brokerage firms to separate research and trading costs. Investors should be able to “purchase and budget for these services as they do any other expense of the plan,” Mahoney wrote.
Gaining traction
Wall Street’s arguments against unbundling seem to be gaining traction at the SEC. And some investors are worried that they are being made privately at the agency, not as part of a public comment process.
“Part of our concern is something seems to be going on behind closed doors,” Ken Bertsch, the council’s executive director, said.
“My sense of what’s going on is brokers want to limit this to clients for whom the European rules apply. But the council would like to see it benefit US investors as well.” How the SEC rules on this question will tell a lot about where Clayton and his new team stand — with Wall Street or its customers.