The Broker's Dilemma

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 this endeavor.

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 cost.

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 in entirety.

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 firms.

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 Stock Exchange.

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.