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Briefing Note BN010/05
29 September 2005

The Financial Services Authority (FSA) has undertaken an assessment of the effectiveness of the regulatory initiatives, including new rules and guidance introduced in May and June of 2004, concerning conflicts of interest in investment research and dealing ahead of investment research.

The assessment involved a thematic review by FSA staff and surveys carried out by consultants NERA and MORI. This briefing note provides a summary of the work done and the key conclusions. A detailed report – Ex-post Analysis of FSA's Conduct of Business Rules on Conflicts of Interest in Investment Research – is available, as are the relevant consultants' reports (see below).

Background

Since September 2004, the FSA has been evaluating the effectiveness of our regulatory initiatives under the objective of promoting efficient, orderly and fair markets. This work was intended to examine whether:

1. firms have devised and implemented effective policies and procedures to comply with the new rules; and
2. clients are able to make investment decisions with a clear understanding of whether research is impartial.

With the help of industry, we produced a series of performance measures (see annex 1 of the report) to facilitate and focus the objectives of this project.

The assessment had three phases:

• Phase 1: Thematic review. The FSA issued questionnaires and undertook desk reviews and firm visits – this covered a number of specific indicators and measures in the performance measurement process.
• Phase 2: Buy-side analysis. Through consultants MORI, the FSA assessed the buy-side's perceptions of the regulatory changes.
• Phase 3: Sell-side analysis. Using consultants NERA, the FSA looked at the extent to which evidence of bias in investment research held out as objective has changed and to what extent dealing ahead of investment research has been reduced.

In relation to the project phases mentioned above, the key findings were as follows:

• Phase 1 – The results from our firm visits and questionnaires suggest that firms are aware of the rule changes and have reviewed their business models in light of the changes. The majority of firms' practices and procedures, mapped against our performance measures, indicate a positive response to CP205.
• Phase 2 – The findings from MORI's study of the buy-side indicate a clear perception that the overall situation regarding the production and distribution of investment research by the sell-side is better now than it was three or four years ago. The trends measured have been broadly positive, to the extent that the buy-side is now more confident about the objectivity of investment research than in the recent past. This study has also produced insights into the relationship between the buy and sell-side that readers may find valuable.
• Phase 3 – NERA's largely quantitative study of the objectivity of sell-side investment research and the existence of dealing ahead provided a useful complement to MORI's buy-side study. NERA's findings on bias in investment research provided clear evidence that the sell-side has successfully adopted measures to manage conflicts of interest, with the results indicating a significant reduction in bias. In its analysis of dealing ahead, the overall picture was positive. From a large sample it appears that behaviour potentially classifiable as dealing ahead is neither prevalent nor economically significant.

Overall Conclusions

Broadly, the FSA concluded that management of conflicts of interest arising in the production and dissemination of investment research has improved and that investment research is less biased.

Buy-side confidence in conflicts management has also improved. Most industry players have implemented conflicts management policies and made the relevant changes to their internal systems and controls. So firms are now working within the framework of the rules. But it is not clear to what degree the change can be attributed to our initiatives, given the wider range of other factors also at work.

The assessment has not been wholly positive, however. The fact that firms receiving investment research still cannot distinguish easily between partial and impartial research is a cause for concern.

At this stage the FSA does not intend to amend its rules as a result of this ex-post analysis. The current regime on conflicts of interest in investment research will be replaced by the EU directive requirements in MiFID¹.

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Consultants' Reports

Mori buy-side survey
Nera sell-side analysis

Footnote

¹ Markets in Financial Instruments Directive