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The economics of independence.

Nov 30, 2002

Over the past few decades the financial services industry has seen an unprecedented aggregation spanning product offering and geographical reach. Banks and insurance companies that had roots in districts or states began to move across borders widening their customer base in search of global leadership and global presence. Not being happy with offering only a deposit facility or a loan capability, banks added a wide range of products to their portfolio of product offerings. The insurance companies, having managed money for themselves in the past, began offering retail customers their investment management expertise. In many instances, banks bought insurance companies or insurance companies bought banks to enlarge the “share of wallet” that they could capture of their “owned” customer.

Not wishing to be left out, many of the larger independent Wall Street firms began offering their retail customers the equivalent of bank accounts and insurance products. Today, these global financé companies offer a host of products for the retail and corporate customers. Like Sears, these financial juggernauts wish to sell you everything from loans to credit cards to stocks. The mantra was “have product, generate transaction”.

The most visible element of this chant for generating a transaction has been in the equity markets. As we have seen from published internal communications, senior executives of respected finance firms were allegedly swapping their integrity for an opportunity to secure admission to elite kindergarten schools in Manhattan. They were willing to let sacrificial investors lose small fortunes in the process. Many times, the motive was plain greed in the forms of higher bonus pay outs from the revenues generated by these compromised opinions. The SEC and the New York Attorney General have called for an end to this blatant exploitation. The proposals have centered on the desire to separate research from the investment banks. But while this may solve some of the problems, it is not the best solution and will still leave the securities industry with an inherent conflict of interest.

The key to this puzzle is to understand that there are multiple functions within a typical Wall Street firm, namely:

  1. There is the research department which generates the stock ideas that act as a catalyst for investors to pursue a course of action with their “buy”, “hold”, or “sell” recommendations.

  2. There is the trading desk that executes the action for the investor on a stock exchange if the stock of that company is already listed, and

  3. There is the investment banking department that brings new stock to the market depending on the appetite and interest of an investor.

The monetary glue that keeps these three very different functions together is the revenues earned from the investors. Consider this. An analyst writing a “buy” report on a listed company like IBM whose stock price is currently US$ 86 would generate a commission income of 5 cents for every share bought by an investor through his firm. The 5cents would make the head of the trading desk happy. However, if that same analyst wrote the same “buy” report on IBM which would result in IBM issuing new shares and having these new shares listed on the NYSE, the analyst would have helped his colleagues in investment banking earn a 6% or US$ 5.16. That would certainly make the head of investment banking very happy. Correction: very, very happy. Under these joyful conditions, an admission to a classy kindergarten school for the analyst’s children or grandchildren would not be a problem.

The SEC and the New York Attorney General are leading the charge to dissolve this financial glue. But so far they are only attacking the more visible 6% fee and not the deceptively small 5 cent fee earned by the trading department. In the days of electronic trading where a typical non-research broking fee is 2 cents for a NYSE stock, 5 cents is a lot – 3 cents more to be precise. Take that 3 cents and multiply it by daily volumes of 1.6 billion shares a day on the NYSE alone and multiply that by 220 trading days in a year and there is a hefty “fee” of US$ 10.6 billion being paid by investors – retail, institutional, and mutual funds – to trading desks at Wall Street firms. That extra “fee” is for the advice of the research analysts. Effectively, investors are paying two bills within that 5 cent charge: 2 cents for the cost of execution and 3 cents for the research reports from Wall Street firms.

If investors still went about buying and selling shares in the same frenzied way they do today but used the electronic platforms that are now gaining in prominence, they would have US$ 10.6 billion to spend on buying independent research or they could use that money to buy more shares. Chances are that if independent research was truly independent and not a department of any Wall Street trading house, maybe the research reports would have some added value for investors and be a little more imaginative than focusing on the next quarter. And the annual research bill paid by investors will probably be less than US$ 10.6 billion.

An independent research firm receiving a flat annual fee for its research would not feel pressured to generate a trade for a 5 cent fee – actions or inactions by their clients would not affect their revenue streams at all. The attention that the internet and telecom IPOs have received - and the exposure of the incestuous relationship between investment banks and research analysts - is well deserved. But in its charge to punish the guilty the SEC and the regulators may be formulating a solution that does not address the more silent, but equally perverse, relationship between research departments and the trading desks of Wall Street firms.

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