The practice of investors using their own clients’ trading commissions to pay for research and corporate access has been under scrutiny for some time by regulators in Europe. To better understand the current wave of regulations and assess their impact on the market, it helps to take a step back and look closely at the economic models of both the buy- and sell-side, particularly the evolution of the commission structure. In this blog we will attempt to put the discussion in context and get to grips with how it affects the relationship between the sell-side and their clients on the investment management side.
The era of fixed commissions began with the Buttonwood Agreement in 1792 in which 24 brokers meeting under a Wall Street buttonwood tree agreed to trade with each other using a basic commission rate of 0.25%. Over the years this loosely organised group evolved into the New York Stock Exchange.
The original Buttonwood Agreement housed in American Finance Museum in New York
With no differentiation in price, brokers competed to outdo each other in areas such as research, technology and other non-product related services to win business. These non-execution, ‘soft dollar’ services were ‘bundled’ together with ‘hard dollar’ services paid for separately and explicitly by the fund manager. ‘Bundling’ became standard industry practice.
In the 1950s approximately 25% of trades in the US were executed through brokers by institutional investors. During the 60s and 70s this number rose to more than 75%, giving the small consortium of brokers unprecedented revenues and power, and bringing their activities to the attention of the US regulator, the SEC.
The SEC was interested in 3 main areas:
- Price fixing: collusion between brokers setting prices
- High fees: unreasonable pricing
- Exclusivity: brokers would only trade amongst each other
As a result of the SEC’s investigation, on May 1st, 1975, the era of fixed commissions for stock transactions ended in the US. The same practice was finally abolished in the UK following the ‘Big Bang’ of 1986. However soft-dollar purchase of research and other services continued in both markets.
In the UK, the lifting of restrictions on the amount of international equities investors could hold led to a surge in demand for equity research, corporate access and other services from fund managers.
While soft-dollar services continued to attract the attention of regulators on both sides of the Atlantic, they were generally considered to be fair game in a free market economy. It was largely left to investors to decide whether the commission they were paying was value for money.
Throughout the late 80s and early 90s the use of soft commission agreements continued to grow. 90s regulation centred more on incremental tightening than structural reform, with much of the focus on disclosure to customers, the obligation to provide best execution and a specific prohibition on soft commission arrangements for certain un-related services.
The Myners Report and the pass-through of broker commissions
A reported delivered by Paul Myners (then chairman of Gartmore Investment Management) in 2011 titled ‘Institutional Investment in the United Kingdom’ addressed the question of bundling and ‘softing’. Myners pointed out that the costs for services provided by the sell-side were not being paid directly by fund managers out of their own pockets, but were being passed through to their own clients (e.g. the pension fund).
The Myners Report prompted action by the FSA (now the FCA) resulting in publication of consultation paper CP176 in April 2013. The report concluded that there was an incentive for fund managers to direct business to certain brokers to obtain additional services, rather than to seek the most favourable trade execution terms for their customers, which the FCA deemed unacceptable.
The Myners review recommended that fund management fees should factor in all additional costs (i.e. for soft services) rather than passing them on to the client, particularly as these additional services directly affect the performance of the fund itself.
Two categories of fees paid to asset managers by their clients
The main difference between the soft commission arrangement and bundled model is whether it is the broker providing the ‘soft’ service, or another third party provider. Under both arrangements, the costs of the services are included in the commission rate (not in the management fee) and are therefore borne by the fund manager’s client and not by the fund manager.
In a soft commission arrangement (prevalent in the US), a fund manager agrees to send trades to a broker and receives, in addition to ‘pure’ trade execution, credits (soft dollars or soft money) which can then be used to purchase services such as research and information, usually from third-party service providers. With a bundled model, the broker offers the additional services (e.g. research or corporate access) themselves.
Commission costs depend on the rates negotiated by the fund manager and the broker, and the volume of trades undertaken on behalf of the pension fund. The fund manager’s client (e.g. the pension fund) has no direct control over either factor.
Soft commission Arrangement
Commission Sharing Arrangements (CSA)
The European unbundling mechanism was the Commission Sharing Arrangement (CSA). In the CSA the execution commission would be retained by the broker handling the trade, while the (larger) non-execution component would be kept on the asset manager’s behalf. As trades accumulated the balance in the CSA account would rise.
How are things looking today
The regulatory debate over dealing commissions that followed CP176 in 2013, has been revived and scrutinised by both UK and European regulators.
In the UK, the FCA’s Policy Statement (PS14/7) published in 2014 created a narrower perimeter for the services and goods permissible under the current regime. The FCA also excluded “corporate access” from the list of services that could be purchased with dealing commission.
In Europe, in late 2014 the European Securities and Markets Authority (ESMA), adopted an equally rigorous approach to the purchase of research as part of the MiFID II inducement provisions. As with corporate access, the message is that fund managers should be paying for research out of their own pockets or charging up-front fees to their clients for the service.
The path from here is perhaps best summarised in last summer’s discussion paper by the FCA:
Overall, we conclude that unbundling research from dealing commissions would be the most effective option to address the continued impact of the conflicts of interest created for investment managers by the use of a transaction cost to fund external research. We believe it would drive more efficient price formation and competition in the supply of research, removing the current opacity in the market. It would be particularly effective if this reform can be achieved on an EU-wide basis.
The final regulations around research continue to be a hot topic and are expected to come into force in Europe by 2017. In addition to the regulatory developments outlined here, other factors such as electronic, off-exchange and intra-buy side trading have continued to eat away at the market share of the traditional broker, resulting in falling commissions and challenging the existing model more than ever.
Sources and additional references: