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Introduced by MiFID II, the separation of payments for research and execution is one of the major factors driving change in the relationship between the buy side and the sell side. Although the intended goal is to increase transparency and ensure investors are getting a good deal, the unintended side effects have been noted by a number of observers.
For example, small cap stocks have suffered as the sell side has cut much of the research provision for these stocks. The reason behind this is that under unbundling, it is no longer possible to subsidise research into these stocks using execution payments. Therefore, for many on the sell side, providing the service is no longer economically viable.
If the larger banks are no longer able to support small- and mid-caps, tier two and
three brokers will need to step in – but Fitzpatrick is concerned that these may not have the necessary liquidity to fill the gap. This would likely further encourage companies to seek capital by other means, such as private equity or even
crowdfunding. But the net result may well be that these companies are no longer
available for investment on the stock market – a situation that will only harm the wider economy.
As a result of all this pressure, the need to cut costs on the sell side has become
a driving force, leading to significant headcount reduction in recent years.
Fitzpatrick notes that sell-side desks that had 25 or 30 people five or six years ago
are now down to eight or ten people – yet these are expected to cover all the same clients as before. Driven by such dramatic change, some sell-side analysts are moving to the hedge funds and to the traditional long-only buy side asset managers.
At the same time, the buy side has ventured into third party research. The problem is the buy side is able to bargain with the independent providers and haggle the rates down, which the independents will accept because they want the business. But if the buy side then take the same rule and apply it to the sell side, that represents a huge fall in sell-side revenue.

“If you think about the cost of an analyst based in London at one of the sell side firms, he is most likely going to have a lot of associated costs like having a graduate trainee working with him, legal costs, compliance costs, data costs, infrastructure costs supporting him which is probably double or triple the cost compared to Edinburgh,” said Fitzpatrick. “So let’s say he costs £100,000 on the buy side, on the sell side you’re looking at £300,000 or £350,000, purely based on the metrics.The buy side don’t look at it that way, they’re trying to work out how much is research worth, and they’re having to justify that to the regulator. The sell side is struggling to adjust.”

On a related note, Fitzpatrick is unimpressed by transaction cost analysis tools that are often used by the buy side to evaluate their own performance.
At Kames Capital, he decided to get rid of the firm’s TCA and do without it -a decision he does not regret in the slightest.
“We junked our TCA because we felt it was an expensive Americanisation and there was no value in it,” he said. “It creates mediocrity – it encourages traders be average, to fit the numbers. I don’t really care what the TCA says. It didn’t improve performance. A large block trade dealt on risk could look terrible on TCA but actually be an excellent trade as that was what the client, the fund manager wanted. There’s no point looking at something that happened three months later. Unless it’s real time TCA (which is much better), I do not believe there is any point in it.”
One other potential problem with the new situation is that it may drive short-sighted
decisions which could harm the functioning of the market. For example, if one industry sector is currently down, the trader may be likely to avoid trading it. This reduces the demand for research in that sector. But with no support coming from execution fees, the sell side may simply cut the cost and fire the analyst. This may be the case, even if the analyst is doing a good job and is highly skilled.

In the worst case scenario, if the sector then makes a recovery some time later, it
is now too late – there is nobody covering that sector, due to the cuts in research
budgets. The buy side then finds it much more difficult to obtain research on that

“Maybe the future way forward is to create a utility for research,” said Fitzpatrick. “I’m convinced that trading is where the profit lies in the future. That’s why when I looked at the Plato project, I felt their focus should have been research, not infrastructure . The banks can’t make provision for research; someone needs to.”

After 42 years in the industry, Adrian Fitzpatrick, former head of dealing at buy-side house Kames Capital, retired in September 2016. A stalwart champion of the long-only institutional investment manager, Fitzpatrick started his career as an office junior at the age of 17 – an experience that he has not forgotten, and one which helped to shape his approach over the years.
“I’ve been incredibly fortunate and I am glad to have worked in the industry, I couldn’t have asked for better," he said. "There’s a great saying, be nice to people on the way up because you meet them again on the way down. I think that’s very true. I never forgot where I came from as office junior and mail boy. I’ve always made the effort to speak to everyone – and I think that’s important. We as an industry are all in this together, and we need to listen and talk to each other.”

Based in Edinburgh, Kames Capital currently manages £51.3 billion on behalf of global clients. The company can trace its history back to 1831, with the formation of Scottish Equitable Life Assurance Society. From 2001 to 2011, it was known as Aegon Asset Management. In 2011, it was renamed to Kames, a reference to the 18th century Scottish philosopher Lord Kames and also the name of a river in Argyll and Bute on the west coast of Scotland, to better reflect the firm’s Scottish heritage.
Fitzpatrick has always spoken honestly about his opinion on issues such as the rise of high-frequency trading – this editor remembers an interview some years ago, where Adrian described HFTs as “vultures”. It was a colourful description that made a big impact and has remained on this editor’s mind ever since. Now though, there are different things to think about; these include TCA (it’s an Americanisation that encourages mediocrity unless it is real time), payments for execution and research
(could the market be moving to an execution-only commissions model?) and regulation (should the markets be run by regulators? Probably not). Perhaps the most urgent question now though is the changing relationship between the buy side and the sell side.

“The buy side are dominant just now. They’ve got control of the budget and they are pushing commissions down year after year after year," he said. "The sell side is getting hammered from all sides at the moment. The regulators are taking punitive measures, and their revenue is under heavy pressure now the buy side is venturing into thirdparty research.”


Adrian Fitzpatrick, former head of dealing at buy-side house Kames Capital

Passive trading
The changes taking place due to unbundling are also linked to the longterm shift towards passive trading, which has been underway for some time but which has accelerated in recent years.
From January 2015 to June 2016, there have been $688 billion outflows from active to passive funds. There are now over 5,100 ETFs, with $3.1 trillion assets under managements. Meanwhile, the top five most active names on the S&P 500 have seen their average daily volume decline by 46% between 2011 and 2016.
This change has been met with some consternation by the global buy side community. While some parts of the industry are seeking to find ways of benefitting from it, others are concerned that the increasing use of passive investing and passive products creates a market more vulnerable to dramatic swings at times of volatility, and one less efficient and less able to adapt in times of crisis, since passive strategies usually just track an index.

“If the world carries on, the way things are going, the active managers are going to struggle and the passive managers will go execution-only,” said Fitzpatrick. “That then places greater pressure on the active managers because people will ask why they aren’t doing the same to cut costs.
But the reality is we need a diversity of participants in the market because we need buyers and sellers. The passive players are all going the same way, it’s the nature of their business. A market where everybody is doing the same thing is not in anyone’s interests”.

If these trends were continued to their logical conclusion, with the majority of market participants made up of passiveinvestors that operate on an executiononly basis, equities might face the prospect of becoming a spread-based market, similar to FX and fixed income.
Such an outcome would probably not be aligned with what the European Commission originally intended with MiFID II. But the theme of unintended consequences is one that is very familiar to the buy side when considering the
impact of global regulation in recent years. The phrase itself has almost become a fixture of discussions on the topic.

“If you look at the unintended consequences, HFT is a great example,” said Fitzpatrick. “That came out of the Dutch auction market. Due to MiFID one, virtually overnight they found an opportunity and they’ve not looked back since. The same applies to fragmentation of trading venues, which makes the market worse because it increases cost and complexity and fragments the liquidity making it harder to get an order done.”
However, that’s not to say that current trends will continue indefinitely. Fitzpatrick believes that there has been a bull market ever since 2008 – a situation
which must come to an end eventually.
And when it does, it could well be the active asset manager that is best placed to take advantage.

“We’ve had a phenomenal bull market since 2008,” he said. “People may not have realised it at the time, but it’s true and it’s stayed a bull market ever since. Sooner or later, we will get a bear market. And when that happens, as stocks move down, the active guys will be able to outperform again as they can react more effectively, whereas the passive traders are just tracking an index.”

Market close
One of the other factors linked to all of the above is the shift towards greater trading activity at the market close. Among other signs of this, K&KGC discovered in our
algorithmic research earlier this year that one of the most popular strategies
is market on close. At the same time, sources on both the buy side and the sell
side report greater activity in the close, while liquidity is thinning out in the intraday
period. For more detail on this, see the Credit Suisse article on page 26.
According to Fitzpatrick, traders like to trade at the close because there’s no information leakage, and because the HFTs don’t play there. A similar factor lies behind the popularity of new platforms such as IEX in the US, which uses speed bumps to ensure that there is no advantage to be had from lower latency.
It also may be a factor in the plans at Bats Global Markets to launch an auction separately from the traditional one operated by the London Stock Exchange and other national exchanges, such as Hong Kong Exchanges and Clearing,
which recently introduced its own closing auction.

Biased lobbying power
Regulation has been a major impact on the industry for a number of years, and in Europe MiFID II has been a central point of debate ever since it first began to be
discussed in 2009/10. While the three main elements in the market may be the
buy side, the sell side and the trading venues, the influence of the three groups
is not equal. On the buy side, it is often felt that despite the European Commission’s
ostensible aim of helping the investor, it is the asset management community that
holds the least influence – while other vested interests seem to hold much more
sway with regulators.

“It’s very true that the lobbying is unbalanced,” said Fitzpatrick. “If I were to
go down to Brussels, I’d be lucky to get a meeting to see anyone. If an investment bank went down there, they’d have a much better chance because they’ve got more clout. But the exchanges are literally based in the next room, and they’ve got the regulators’ ear. They can influence the regulation and they have done and that’s a problem. They want a market that suits them, not necessarily
one that is in the interests of investors.”

Recent political events will also play into the debate. The election of Donald Trump as president in November 2016 was a surprise to many. But from a financial services perspective, Trump has indicated that he intends to deregulate the US banks, including watering down or reversing parts of the Dodd-Frank legislation. The end result of such a move would likely be a boost to the US banks, which would then be well-placed to increase their profits and potentially become acquisitive. At the same time, there is little to no prospect of European regulators following such a route, despite the struggling situation of many of the major EU economies.
“The EU banks are really going to struggle, because they will be tied down by the burden of EU regulation and MiFID II. If the US banks surge ahead, they won’t be able to compete and that’s going to be bad for the outlook for Europe. It could be that it’s the US and Asia that are going to be leading the way in the future and Europe will fall behind. My question to the industry would be, should the market be driven by regulation? Is that really the sort of market we want to have?”
The relatively severe European regulatory approach can also be highlighted by
actions designed to make bank executives personally liable for mistakes and failures.
Regulators in Europe have systematically targeted the top executives and made
them terrified of draconian punishments including bonus clawbacks, fines and
even jail time. But there is (and has been for a long time) a sentiment that the regulatory changes may be going too far. This editor recalls a conversation with Anthony Belchambers, at the time president of the Futures and Options Association, back in circa 2012 when he mentioned that the regulatory train may be running away out of control. It is a sentiment shared by Fitzpatrick.

“Would you encourage your kids to go into this industry? Knowing that salaries are getting cut, bonuses are being capped, and if you make a mistake you could end up in jail? It’s good that people are accountable but this goes too far,” he said. “The result is that banks are struggling to get the talent they need. No one wants to be on a bank board. They don’t want to be hung drawn and quartered if something goes wrong. I think the government will realise eventually the damage all this regulation is doing.”

Fitzpatrick on Brexit:
“I think the UK has set the ball rolling
in a way that may force the EU to
take a look at itself and move away
from the globalisation that they’ve
been doing and the federal state. The
Dutch prime minister and others are
not happy, they probably agree with
the UK they just haven’t gone as far as
leaving the Union. They might use the
UK as a reason. If you think Greece,
Spain, Italy, they’ve got huge issues
and those issues aren’t going away.
They are stuck in an organisation
they have no control of. Maybe it’s
time to rein it back in again.”



Fitzpatrick on Trump:
“Globalisation is a huge factor. Trump
is Isolationist. He says he’s going
to make America great again, that
he’s going to re-open the factories
in Pennsylvania. The only way
he’s going to do that is to stop US
companies from going abroad. Has
globalisation gone too far? It’s a
valid question to ask. Most people
inevitably go to the cheapest price
possible, and that’s always in India
and China because they have a large
surfeit of population willing to work
at very low cost.”


Elliott Holley
Head of Global Buy-side Research
+44(0)7759 476779

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