It is apparent that Wall Street is
walking through the valley of the shadow of death, as the well meaning
public is increasingly becoming aware of the conflicts of interest
related to its research enterprise. The conflict is in differentiating
between sell-side and buy-side analysts. The former is the traditional
brokerage analyst. The latter is an investment-banking analyst,
a product of corporate finance. The dealmaker, or sometimes, just
the dealmaker's analyst. I have a name for them, but that's too
crude even for an underground writer to say here.
In fact, even the brokers at brokerage
firms can be either buy-side or sell-side.
The question is arising again on
how to deal with the difficulty of ensuring that a research analyst
stays independent. As a consequence of the bear market that none
of the geniuses running the show counted on coming in the first
place, brokerage firms that have failed to make the distinction
clear to the public are going to be liable, period. This is reportedly
going to cost billions of dollars for those failing the worst in
Yet, it isn't the first time this
question has arisen. Brokers have worked hard on this problem over
the years by building a wall between corporate finance and research.
They found that they couldn't due
to the lure of profit there was in pimping research for corporate
business that was nothing short of flattering. Now it's going to
But the irony is that while they're
going through all of this, and figuring out how to build an even
better so called "Chinese wall" (to ensure independence), which
can never really be thicker than a wet tissue, an army of independent
analysts expert in their own fields is growing in a free market
environment permitted by the age of the Internet.
So the Chinese wall may yet again
face obsolescence now that information monopolies have been shattered,
on account of the new medium for information that has allowed individuals
to acquire and publish information from virtually anywhere, cheaply.
In other words, up until now, the
investor had few options but to get his information from the broker.
That monopoly has vanished. What's more, the cost of producing research
has fallen. Data services are cheaper and plentiful, while publishing
costs have dropped markedly. I doubt there could be a field that
the revolution in information technology has benefited as much as
the field of analysis. And there is nobody that can benefit more
from such gains in productivity than the average citizen.
Increasingly, research departments
at brokerage outfits are going to have to make a choice, whether
to produce for corporate finance, or whether to produce for clients
at the retail level. Their energy could be spent on that decision
rather than on how to build the best wall. Or maybe the brokerage
firms will have to choose between being either one or the other
But there is a dilemma. The main
problem for the buy-side firms would turn out to be that without
"distribution" in the first place, their corporate clients would
have no use, or less use, for them. Moreover, brokers depend on
sell-side analysts to rebuild their credibility for them when the
market takes down their investment bankers.
Most corporate client's business
comes with the expectation that the brokerage firm where it does
its business will put out flattering research reports. I'm not sure
how the brokerage industry can get around that except to say ahead
of time, we're either buy or sell side here. But even there would
require regulation because they are as intertwined in the investment
business as the "oldest profession in the world" is with society.
After thinking about it for a while,
it seemed that trying to regulate the separation could introduce
as many problems as trying to regulate the previous Chinese Wall,
if not more. Besides, as we said, the buy-side firms couldn't exist
without distribution (assuming we're going to stay in the
age of boom-bust cycles during our lifetimes).
However, there is still a need for
underwriters to exist. Investment banking and corporate finance
are an important part of the market, particularly as regards the
process of financing industry. Somebody has to take the risks these
people do. The stock market's
most worthwhile role is probably as a conduit for risk capital into
industry. For the company it is an alternative financing option
and therefore stokes competition in the financial industry. Isn't
that what we want to happen?
Maybe nothing needs to be done at
all in terms of more regulation. If the product of the last bull
market is a larger bill to the brokers losing litigation to clients
they have ripped off then justice was already served to a degree.
Nothing hurts quite like getting it in the wallet. From what we
saw in the bull market, many of these brokers deserve it. But if
punishments don't work to deter future indiscretions than I doubt
regulaton will. It's easy enough for people to figure out how to
get around regulation, but whether or not they choose to would depend
on the punishment, don't you think?
That said if they have to deal with
any extra regulation it is their own darn fault for raising the
ire of the public eye.
But maybe clients too have to become
more informed, particularly with regard to how they might find the
right broker, someone they can trust. How many clients litigating
against their brokers now for instance knew full well that if so
and so didn't work out they'd be suing anyway? It's a sure thing
thanks to the abundance of regulation already in place. The public
is full of deceptive individuals and they don't all work at brokerage
The lesson here I think is that brokerage
firms are going to have to learn how to please all of their clients.
They will have to realize that the value of being a middleman lies
in pleasing, and bringing together, both sides in a transaction.
If the Internet and market is left
to its own devices, the investor will have increasing amounts of
resources at his or her disposal. Substantially more than ever.
Just like the market goes through booms and busts, the industry
will go through phases and fads where investors clamor for new issues
and forgo independent research despite its availability. On the
other hand, there will probably be times when investors value independent
research highly. Human nature is what it is.
Nonetheless, the more society can
foster the growth of such independent research, the more competitive
pressure there will be on the firm's analysts to satisfy both sides
or risk losing retail business to the discount houses.
That's how a market should work.
As the independent analyst becomes sought after by individual investors,
he or she will also be sought after by the investment banking community
seeking to raise money. And so the process repeats and repeats.
New up and coming analysts can break through the mold this way,
as the old ones fall to the wayside. For in the end, they will have
a choice. Either they will have integrity or they won't.
Indeed that is where the news is
today, isn't it? The failure of brokers to properly value and balance
both sides of their business with integrity is the foremost problem,
but the solution could be as simple as letting the market better
regulate their integrity.
Certainly, to the extent regulators
decree that analysts' pay packages shouldn't have corporate finance
incentives built into them, the spotlight ultimately shifts away
from the analyst and directly to the broker or investment banker
who would then be accountable for what his or her analysts recommend.
The criticism deserves to go to the
brokerage community, but if we all take the line that we should
protect investors from themselves by building one safety net on
top of another, the protection could cost market liquidity. An example
of over regulation in a particular exchange could be the Vancouver
After years of abuse the exchange
was perhaps forced to overcompensate, which led to its demise in
the final analysis. Before it did, liquidity gradually dried up.
Power to the market and recourse for investor litigation, but no
more regulation please.
In the end, a market is only as good
as its self-governing members' integrity. Take heed Wall Street.