Proprietary Trading & Research Divorced?

Two weeks ago, a relatively small group of people became quite upset with FINRA when it announced a proposal to adopt its Consolidated Rulebook Interpretive Material IM 2110-4. Basically, this document means that the SEC is moving to enact a proposal to prevent proprietary trading operations at broker dealers from being able to use their in-house research material to their advantage before that same research material is made available to their clients.

Now to us, this doesn’t seem to be illogical. But some of the outrage by others at this proposed rule is interesting (the lady doth protest too much, methinks.) The brokerages and investment banks that are angered by the rule are making the case that “they have no way to pay for research remaining other than to have their clients actually pay for it.” In other words, their research and research services departments must actually make money for themselves, rather than being paid for by the prop trading department (as this rule will prevent that) or by investment banking revenues (which was destroyed at the hands of Spitzer several years ago.)

Research and Prop TradingOne article that was written Stephen Nelson and published by Investment News (click here to read) gives a very good synopsis of what the situation is for brokerages that produce research. And I must say, I don’t miss Stephen’s points, but he fails to really lay out the real reason why this makes sense. Yes, it is true that research will again be without an internal revenue stream from prop trading, but let’s examine quickly why this is.

Hypothetically, this is the path that a severe downgrade can take from the research department of a major investment bank. Let’s say the research department decides that they are going to change from a raging “BUY” rating to a freezing “HOLD” rating on Tuesday morning of next week. When this report comes out and is published through FirstCall and then read on CNBC in the morning, and then the Analyst makes 5 television appearances all within the span of that Tuesday morning, it is VERY LIKELY that the stock will decline. Not necessarily because it is the right call, but because the research departments and dissemination machine that supports them have enormous market manipulating ability. Not in a bad sense, but in reality, they can manipulate stock prices just by publishing a downgrade.

So before this happens, under today’s current rules, the analyst can call the proprietary research desk (and will) and say, “Hey, head’s up, I don’t like this stock anymore, and I am going to downgrade it Tuesday morning.” What does the prop trading desk do? What would you do? Of course, they effectively short the stock, or sell out of any position in it.

Prop trading is an odd hybrid of a buyside shop focused on investing, and a sell side shop because they are, in fact, part of a broker-dealer. It has forever been part of the game that makes both individual and professional investors very nervous, because their access to information including what their research department will be doing in the no-to-distant future, and the information on what their clients are trading, makes them a bit too “prescient” at times. In a fair market, it just seems a bit “un”.

So the new rule basically states that this won’t work anymore, and it must stop.

Why is this possibly a big deal? Well, for some brokerage firms who make a significant portion of revenues from their prop trading operation, this could limit their ability to leverage their own research for profit. Goldman Sachs (GS) is notorious for a great prop trading operation as is Morgan Stanley (MS). However, both of these firms have been cutting back on their research staff in recent months, and in truth, probably don’t leverage the same research modeling on the prop desk for trading as they do in the research that they publish to clients and Joe the Investor.

So will this rule change hurt the brokerage industry? Probably a little, but not necessarily in a bottom line sort of way. More likely, it will be yet one more department (the prop guys) who no longer has to share their earnings with the research department, which, incidentally, will suit the prop guys just fine.

Goldman Sachs

And what of our friends in the brokerage house research departments. Well, their options for payment are running out. They can’t be paid with investment banking revenue (directly, although they can still be paid indirectly) and they can’t be paid by prop trading anymore for advance research access. So how on earth will they get paid?

As we keep saying, research on the street is changing. And as with all innovation, there is an establishment that is not happy about that. What is likely to happen is that this additionally blocked revenue will continue to force the research evolution at big brokerages. Some analysts will leave their firms for greener pastures and the biggest firms will continue to cut jobs and cease analyst recruitment.

Morgan Stanley

Until Wall Street ceases providing ratings on individual companies and instead focuses on broader, theme focused and insightful research, it will be a losing proposition. Clients, both institutional and individual, are demanding a different more cost effective model.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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