Title: The Evolution of Bundling and Unbundling: The Impact on Stock Research
Introduction:
In 1995, Jim Barksdale, the CEO of Netscape, made a significant observation that resonated across various industries: there are only two ways to make money – bundling and unbundling. While this concept has been widely applied in software and other sectors, it has had a contrasting impact on the stock research industry. This article examines the effects of unbundling on stock research, particularly in the European Union (EU) under the second Markets in Financial Instruments Directive (MiFID II). It also explores the recent efforts by European lawmakers to reintroduce bundled research and discusses the consequences experienced by key players in the industry.
Unintended Consequences of MiFID II:
Since the implementation of MiFID II in 2018, money managers in the EU have been required to separately pay for trading and research. While the goal was to create transparency and remove conflicts of interest, it resulted in unintended consequences. The European Commission acknowledged that these rules compromised the availability of research, leading to reduced capacity in the industry. Furthermore, the expiration of the waiver allowing US and European models to operate concurrently added to the uncertainty faced by European asset managers.
The Push for Bundled Research:
Recognizing the limitations of unbundling, European lawmakers are now working to lift the ban on bundled research. The EU aims to increase flexibility for investment firms in arranging payments for research and execution services, according to a negotiating mandate from the European Council. The move comes as a recognition of the need to adapt the rules to better serve the industry and enhance research availability for market participants. However, this U-turn may come too late for some brokers who have already exited the industry.
Impact on Key Players:
Redburn, a UK-based company founded on the principles of comprehensive research and top agency execution quality, saw a significant decline in revenue since MiFID II’s introduction. From £96.4 million in the financial year before the new rules, its revenue dropped by a third to £63.5 million in 2021. These financial challenges led Redburn to agree to sell to Rothschild & Co. Bernstein Research, another major player primarily focused on the US market, experienced revenue declines in six of the last seven years and was grouped into a joint venture with Societe Generale SA.
Understanding the Economics of Bundling and Unbundling:
The upheaval caused by unbundling in stock research shouldn’t come as a surprise. Economists have long known that bundling works best when two conditions are met: high variance of demand and zero marginal cost. Equity research satisfies both of these conditions, as it is challenging to price on a stand-alone basis, and the cost of research is relatively low compared to the value it provides to fund managers. The unbundling approach failed to consider the inherent conflicts of interest and failed to find economic viability.
The Lessons Learned:
The bundled research model has proven to be more successful and sustainable in the stock research industry. Efforts to unbundle or separate research functions from other financial services, both in the US and Europe, have faced challenges and failed to address the core issues. The recent move to reintroduce bundled research in the EU demonstrates a growing recognition of the benefits of this model and the need for flexibility in payment arrangements.
Conclusion:
In the world of stock research, the axiom shared by Jim Barksdale that there are two ways to make money – bundling and unbundling – has taken on a unique meaning. While unbundling has disrupted the industry and caused unintended consequences under MiFID II, the push to reintroduce bundled research in the EU highlights the need for a more flexible approach. The challenges faced by key players like Redburn and Bernstein Research highlight the significant impact that unbundling has had on their business models. The future of the stock research industry will depend on finding the right balance between transparency, conflicts of interest, and economic sustainability, ideally through a bundled research model that meets market demand and maximizes value for all stakeholders.
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Investors at the Barksdale roadshow at the Savoy Hotel would return to office desks overflowing with investment research sent out daily by brokerage firms. Such research never came with an explicit price – it was simply included in the cost of trading. In the US, this is still basically how the market works.
But since 2018, the European Union has required money managers to pay separately for trading and research under its second Markets in Financial Instruments Directive (MiFID II), an experiment that hasn’t worked. The rules ‘may have compromised the overall availability of research’, admitted a memorandum from the European Commission late last year. Instead of creating the conditions for making money, unbundling turned research into a money drain and capacity left the industry.
Although the Securities and Exchange Commission issued a waiver to allow US and European models to operate concurrently, it expired this week. Netscape (purchased by America Online in 1998) is long gone, but European asset managers have remained in limbo on how to source investment research on US stocks.
Luckily, they may not have to wait long. European lawmakers are now trying to lift their ban on bundled search.
In 2021, the EU went a bit of a backwards step by allowing the search for small-cap stocks (below €1 billion in market value) to be brought together in the trade. Now they want to go further. “The rules need to be further adapted to give investment firms more flexibility in how they wish to arrange payments for research and execution services,” notes a negotiating mandate from the European Council.
For brokers who have already left the industry, the U-turn comes too late. Redburn, a UK-based company, was founded 20 years ago “on a passionate belief in the importance of in-depth, uncompromising and fundamental research and service to clients, particularly when enhanced by top agency execution quality”. MiFID II has turned its business model upside down. “It has had a considerable impact on industry practice,” the company wrote in its 2019 annual report. “Particularly relevant to the Company has been a significant reduction in the market portfolio of aggregate equity research.”
From a peak in revenue of £96.4m ($122m) in the last financial year before the new rules were implemented, Redburn’s revenue has dropped by a third to £63.5m in the calendar year 2021. Before waiting to see what 2022 had in store, the company agreed to sell to Rothschild & Co.
Bernstein Research is another company that has suffered. While its business is centered around the United States, it has seen revenue declines in six of the past seven years. Late last year, its parent AllianceBernstein Holding LP grouped it into a cash-share joint venture with Societe Generale SA.
That unbundling would create so much upheaval should come as no surprise. As economists know, bundling works best when two conditions are met: high variance of demand and zero marginal cost. The former makes it difficult to price the product on a stand-alone basis; the second guarantees that it will never be sold for less than cost. If a product costs $100 to produce but the market only values it at $50, profit can be maximized simply by discontinuing it; if it costs $0 to produce, some value can be captured by including it as part of a package. Stock research, like many information assets, satisfies both of these conditions.
However, because the value of equity research goes to the fund manager while the value of trade execution goes to the client, the model incorporates conflicts that have long begged to be examined. The further conflict of research building into a marketing front for advisory and underwriting functions in the early 2000s convinced New York Attorney General Eliot Spitzer to lobby for investment banks to spin off their research units entirely. But the proposal was also abandoned due to the poor economic prospects for independent analysts in such a spun-off company, and softer separations were imposed instead. Subsequently, in 2007, the chairman of the Securities and Exchange Commission floated the idea of unbundling and, again, it was unsuccessful. How Europeans are learning: The bundled model works.
That’s not to say that some disaggregated searches can’t make money, as evidenced by the plethora of financial Substacks (mine included!). But we’re still a small beer in the context of the whole research industry.
The research bundling has now survived multiple challenges throughout its history: from reducing brokerage fees to regulatory intervention to European bureaucracy. Barksdale may be right that in most industries, there are two ways to make money; in stock research there is only one.
More from Bloomberg’s opinion:
• It’s not easy being a stock market villain: Marc Rubinstein
• It’s too late to save analyst jobs from MiFID II: Lionel Laurent
• A bigger bonus for bankers? UK plays with fire: Marcus Ashworth
This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.
Marc Rubinstein is a former hedge fund manager. He is the author of the weekly finance newsletter Net Interest.
More stories like this can be found at bloomberg.com/opinion
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