The Breakdown of the Broker-Dealer Model

The three components of a broker dealer: corporate finance, research, sales & trading, are all dependant on each other in order for the firm to make revenue. If one of these three units broke down, the investment bank would become unprofitable, correct?

I am proposing a prediction that the equity research component is breaking down and at some long-term point (5-20 years), investment banks will be completely out of favor.

Industry veterans have commented to me that “back in the day” sell-side research analysts had a real advantage over the average investor because they had real access to management. Models could be sent back and fourth from the analyst to management and if the analyst was off in their forecast - management could let them know about it clearly and succinctly. In essence, the market was more efficient.

These days, the analyst and management are more separated (rightly or wrongly, probably rightly) and analyst predictions suffer from lack of management input as a result of tighter information regulations.

Another matter plaging sell-side research is the inherent conflict of interest between providing objective research, and pleasing corporate finance. If an analyst acutally provides true un-biased research, it is more like contributing to the public good and it is not a self-interested move. Contributing to the public good is not a profit-maximizing move for the investment bank. The credibility of the research is hindered - before it is even written.

I believe that a good chunk of research analysts may sublty design their models and assumptions to be accountable to the client company and not the instituional investor - even when their own common sense may tell them otherwise. Using company guidance is a safe bet, the company can’t get mad at you - but there is not thought that goes into it and therefore no value in the research reports.

Equity research analysts have tended to stay out of the scandal spotlight, probably because they don’t actually spend, invest, or otherwise handle transactions. The facebook launch brought it a little to attention, but I say the problem is much deeper than it appears.

Without credible research, a trading desk has difficulting attracting trades, and without trades, corporate finance has difficulty attracting deals. Investment banks were the hotspot to be, now I think it is on its way out. I don’t know what will replace it, but something else will.

  • former equity research associate

The whole industry is contracting.

It’s about time the brightest in our society go into medicine and science instead of trying to beat their benchmark by 0.000001%.

I’ve been an ER analyst, those comments are from a rookie. There’s some element of truth here and there, but not exactly the right reasons.

First, there’s no way ER as a whole will go away. Companies will always need coverage. ER needs to contract surely, but because there is way too much sell-side out there. A company doesn’t need 30 analysts, and any buysider can tell you about the flood of SS spam email/VM/calls every. single. morning. Once you cut off the irrelevant analyst’s, the ER that survives will become more profitable again.

As commissions have come down over the last decade, volumes still remained high, so on a net, it was still ok. But the past few years, volumes have come down significantly, and too many people are trying to fight for the remaining commissions. Access to management still brings in good money to SS shops

Coming from the S&T side, my perspective is that we can function without in-house equity research. In fact, my company’s equity research sucks; they might as well just disappear (of course, I will not admit this in real life). We either use third party research or the sales people make something up. For trading, “color” provided by brokers is more important than fundamental research.

Yes, an in-house research department can be somewhat useful, however, the rest of a broker dealer can function without it. In theory, research is supposed to be separate from the other functions. If it’s one of those research desks that only supports a sales pitch, they will not be trusted anyway.

When Obama wins a second term, get ready for Wall Street to dismantle. I can see a regulation similiar to Glass-Steagall returning completely breaking up the whole investment bank business model. Firms will go private to limit the excessive regulations that public companies not only face, but also financial service companies. 99% of the public hates the 1%ers, rest assured Obama will appease them by pounding the gavel demanding reform.

On another note, Sell Side ER is a commodity at best. Most of it is just investor relations propaganda put forward by the lowly BB associates so the big MDs can secure corporate finance deals. Every report I see has some disclaimer indicating, “Research is paid based on x, y, and z which includes investment banking revenues.” Furthermore, would anyone dare trust SS ER? I can see Iteracom coming out and bashing me saying, “Really, we have hedge funds as clients buying our sht!” True, I bet you do. But I doubt Asness and Griffin are chomping at the bit placing their leverged bets on your bespoke research. They buy it as a scapegoat. When sht goes astray, they can say, “Hey Mr. Client, we did our best, if anything GS, MS, etc screwed us by giving us shoddy research.”

Let’s look at it this way. As my man Klarman would say, buyside eats their own cooking. Why trust a bunch of sell-siders who have everything to gain and nothing to lose by investing other people’s money.

SS is good for bringing you up to speed on a new company. That is, they help you understand the drivers of profitability, historical performance, and what the company is saying for guidance.

Most SS has pretty crappy valuation, so I wouldn’t trust it. I rarely see someone do anything but forecast out management’s guidance, slap an arbitrary multiple on it and call it a thorough valuation.

Is it true sell-side research has not always been this tainted and irrelevant?

And do you guys see the fall of sell-side research bringing down the broker dealer model?

No, why would it ? Companies will always need to raise money, and investors will always be investing in securities. With or without in-house research.

What I see is research being increasingly outsourced or outright purchased from bank-independant providers.


It’s not irrelevant. You have no idea what you’re talking about, and clearly have no idea how the business works

Disclosure: I’m not a SS ER analyst, so I’m not biased here.

I feel a bit daft for saying this, but what exactly *IS* the broker-dealer model? Can someone explain what that is?

As far as I can see, investment banks get paid to 1) value company securities, 2) buy off large blocks of stock and/or bonds in exchange for cash, usually at some small discount to their estimated true value plus some fees, and 3) find other people (retail, pension funds, endowments, whatnot) to purchase them at something closer to their estimated true value, thereby making money on the spread.

At some level, there does need to be valuation research of the target firms in order not to overpay for stock, but that is not the same as SS equity research, even if the skill sets overlap.

SS equity research might help with the sales of those securities, particularly in developing the relationships that might be necessary to unload them, but I could imagine that there might be something else that takes its place.

I really don’t know exactly what it means to be a broker-dealer, and I feel strange to admit it. I sorta get the gist, but I can never really put my finger on what a broker-dealer is, as opposed to an investment bank, or other kind of organization (like an asset manager or hedge fund). At some level, they start to blur together, because they’re all engaged in trading of some sort.

Can someone else clear the air? I suspect that many people don’t really know that well either.

Also what is “color” that you refer to Ohai? Thanks.

“Color” is just clarification about things that happen in financial markets. Talking to brokers or dealers can, for instance, give you hints or tips about who is trading certain things or how market sentiment might affect various prices. For market making activity, this can be more important than fundamental research.