Equity Analysts at Nomura in London were left in shock this week as Nomura announced the restructuring of the equity research department. In a statement Nomura said:
“since the second half of last year, global markets have experienced extreme volatility and a significant decline in liquidity”
When you look at the facts however, there is little evidence of a such a significant decline in liquidity– average daily volumes on the LSE and Euronext are more or less stable year on year, while bid-ask spreads in cash equities have seen only a modest increase year on year. Analysts from Nomura that I’ve spoken to say that business was fine in cash equities. So what’s really going on?
In my opinion, this move has very little to do with current liquidity conditions and much more to do with a changing regulatory landscape and a structural shift in the profitability of the client base. The three key factors at play are as follows:
- Regulation on the buy-side
- Regulation on the sell-side
- A secular shift in active management
Regulation on the buy-side
With MIFID II around the corner, asset managers are preparing for a massive change in the way they measure and pay for equity research. Regulators will require buy-side firms to create Research Payment Accounts (RPA) – where the budget must be set in advance rather than linked to the volume of transactions (so-called unbundling of research and execution).
This is likely to be painful for traditional brokers where research fees were collected via execution of trades. With increasing transparency, more funds will divert fees away from execution brokers and allocate more towards independents. While the regulation in Europe may not come in until January 2018, there will be a steady evolution towards greater transparency over the next 18 months.
Regulation on the sell-side
Traditionally equity research has helped to generate fees for other parts of the bank – key amongst them the investment banking division and the prop trading desk. Successive regulation has strengthened Chinese Walls between research and the IBD, while forcing prop trading divisions to shrink drastically. As linkages to these other divisions declined, the cost associated with a full research department has become far more obvious. While many research departments have cut costs by reducing headcount, compliance cost continued to rise as sell-side firms try to manage these multiple conflicts of interest. At some the economics start to look unsustainable.
Decline in Active Management
Traditional institutional clients have been going through a huge amount of turmoil themselves. Active funds are increasingly migrating to passive, where trading volumes are much lower and the need for research is entirely absent. Active management is alive and well, but it’s increasingly fragmented, with many smaller hedge funds taking the place of these large institutions. The structure of a sell-side firm makes it difficult to profitably cater for hundreds of small hedge funds.
This leaves brokers to focus on the large hedge funds, where trading volumes are high and fees are still lucrative. Yet with so many brokers now focusing on this space, competition for these clients is intensifying. Not all of them can survive.
I suspect that Nomura is not the only equity research firm currently considering their options. A shrinking revenue pool cannot support such an expensive infrastructure for very long. Many banks increasingly see equity research as a problem child, rather than an essential part of their infrastructure. Here at StockViews, we see a strong future for equity research, but we also think the structure of the industry needs to be completely redesigned for this new landscape. As talented sector analysts leave the sell side we hope that many of them will find a new home here.