The RaaS Revolution

For all of us tech geeks, the past decade or so has brought about the evolution of an important enhancement to the software business – Software as a Service (SaaS.) Essentially, SaaS means that customers (as explained by Wikipedia) ‘do not pay for owning the software itself, but rather for using it.’ In other words, although the end user may not pay $100,000 to own the software, they will pay the software provider $1,000 a month to utilize the software.

This is a win-win scenario – it means that the end user makes a smaller commitment (often on a monthly, or quarterly basis) – so there is flexibility in case it doesn’t work out – which is often an enormous hurdle in the purchasing process; the software provider is servicing the account, so the end user has an ‘on call’ service center to help them with any issues; and it works in the favor of the software provider because the client is paying them on an ongoing basis, which helps the company to establish a more long term business model.

SaaS may have taken some time to evolve, because this is not the way people were used to paying for things, but we do believe it’s here to stay. As we said in a blog earlier this week: If you show people a more reasonable way to do something that they’re already doing, you can, over time, shift their behavior.

We believe that this model can be (and is being) effectively replicated in the investment research world – or, more specifically, how institutional investors pay for research.


“Just Because It’s Always Been Done That Way Doesn’t Make It Right”

Research has traditionally been provided to portfolio managers and investors as an ‘add on’ to a trade. More or less, a ‘pay-for-play’ for ideas, where a sales trader calls with a great idea, and the PM appreciates the idea, so he kicks a few hundred thousand shares to the trader to execute, and those commission dollars (or pennies, really, as the case may be) cover the expense of the idea.

However, as commissions shrink, this model faces a serious threat. If commission compression means that there are less commission dollars to put toward research (to cover the overhead of having a research desk at all) – then research becomes a cost that cannot be covered or justified by the firm. The only way a firm can then justify the research is on volume rather than pricing. However, to be dependent on volume alone because commissions are almost completely compressed is an extremely risky business model, because it means there is no ‘cushion’ built in to pricing that helps you weather dips in your volume.


RaaS: Creating the Category

Research-as-a-Service, we believe, is the future of the research business, in the same way that SaaS is the future for software. Providing access to analysts as well as research, on a limited distribution basis; a payment schedule and commitment period that is comfortable for the end user, but provides a steady income stream for the provider; encouraging provider-customer interaction and feedback – are the key components to an ongoingly successful business model in the RaaS category.

The ‘Race to Zero’ Zooms On

The fact that commissions are drying up, and that brokers are competing over a half or a quarter of a penny at this point to win execution dollars, is nothing new. However, the Race to Zero will kick into high gear in 2008, as research desks get slashed at large firms (which used to be an ‘add on’ that justified higher execution pricing), and the surge in unbundling execution from research sends clients searching for best execution providers.

Brief History

With the onset of the tech era, commissions started facing their first hurdles in the 90’s. New execution providers flooded the market promoting faster and cheaper execution than ever before. Existing brokerage firms were able to implement similar technologies that also touted volume scalability that kept them in the game. As technology improves commissions become increasingly more commoditized, and thus coined was the ‘Race to Zero.

Current State of the Union

Large brokerage firms now look primarily to volume, not pricing as the key to feeding the execution beast. However, as most large brokerages look to slash their workforce, the research departments – long considered a ‘cost center’ and often referred to as the ‘red-headed stepchild' of the brokerage world – will certainly take a hit. With less research being written internally to justify higher execution pricing, unbundling research will almost evolve organically from the current issues in the market.

Mid and small executing brokers who provide research – despite their hopeful musings that the sky is not in fact falling - are facing some trouble. Many seem to have hung their hat on the idea that hedge funds want to continue to use an over-abundance of executing brokers, so that competitors won’t be able to follow their trading patterns. Based on our talks with market insiders, this notion seems rather unreasonable. We’re not suggesting that any hedge fund out there is handing his entire trade book over to one execution firm, but minimizing the number of executing brokers is not only something most have said they’re willing to do – from a cost point of view, it’s a priority.

Mid and small guys who recognize the threat on the horizon still have the opportunity to choose a business, any business – either research OR execution – not both – and have a chance at survival.

In-House Research: Threat Level: Elevated

Tumultuous markets are leading to an increasingly treacherous landscape for in-house analysts at large and mid-sized firms alike. While the majority of the blame game is taking place in the credit arena, soon, it is likely to penetrate other areas as firms search for ways to regain some of their lost revenue. Before long, the in-house research desks will be asked to stand before the tribunal and prove their worth.

In-house research has been the red-headed stepchild within firms since the fallout in 2001. Seen as a cost center, the research desk has been tossed around from division to division within firms, with no one wanting to take on the ‘overhead’ of supporting them. In a tightened market, the ‘hot-potato’ toss will likely resume for who is responsible for the in-house trading desk.

Are the days of in-house research over? Will we see all research end up being outsourced, where firms can more easily scale their usage of research with the rise and fall of commissions and revenues? It would seem that the day is nearing where these questions are seriously asked.

In any case, it is likely that an increasing number of great in-house analysts will jump ship and move into the independent side of the business to places like StreetBrains.


Making the case for independence

While having a big firm's name to put on your business card used to grant instant credibility for analysts, now, many industry peers will instead make the assumption that your research is a) tainted or b) commoditized. You turn on CNBC, and more and more lesser known firms are popping up as credible, independent sources, whose insights are not commoditized. The playing field is leveling – and rightly so – where the success and credibility of an analyst is more a reflection of track record than affiliation.

Independent analysts are also helping their own cause by proving time and again that it’s not just the big boys who have the tools to get calls right. On the contrary, in a constricted market, it’s hard to ignore the possibility that leaks and cracks in those ‘Chinese walls’ between investment bankers and research desks may deteriorate quickly when a firm’s best interests are at stake. For many institutional investors, it’s just not worth the risk to rely on this type of questionable intel when placing big trades.

So, while highly scrutinized (sometimes unfairly) large investment firms walk the tightrope of finger-pointing and protectionism – the path is being cleared for independent analysts to step up to the plate and establish their value.

While the internal battles ensue at the big Wall Street firms, those analysts who have found the right formula and business model are in a position to capitalize.