As UK’s FCA and European regulators continue to clarify their stance on commission ‘unbundling’ we thought it might be useful to quickly revisit the debate and attempt to answer a few questions at the core of the debate.
To recap (also see our earlier piece: Brief history of the dealing commission), most equity commissions paid by investors to brokers are split into two components: execution and non-execution. The execution component pays for the physical cost of trading and clearing a transaction; the non-execution component pays for other services such as investment research and corporate access.
Commission sharing arrangements (CSAs) enable fund managers to keep the two components separate, however until recently they have tended to be ‘bundled’ together into one commission payment. CSAs have been criticised for their lack of transparency in helping fund managers to determine the value of the services consumed and to control spending. Furthermore, even though the fund manager has full discretion in how the commission is spent, it is paid for by the fund manager’s end clients.
In Europe at least, we seem to be heading towards complete unbundling, which will likely have profound implications for asset managers, sell side firms, IR teams and entrepreneurs alike
1. How have global trading conditions affected made the supply of research and corporate access services?
The post-credit environment has ushered in the most difficult period for equities since the 1930s. This is due to a huge combination of factors: depressed equity valuation, lower trading volumes, lower fees generated from IPOs and primary market activity, equity market fragmentation and HFT, and a steady shift from active to passive investing. All of this has contributed to a significant decline in available commissions for equity businesses providing research and corporate access. Emerging markets have fallen prey to additional dynamics, which have further reduced commission dollars from trading and caused banks to scale back their securities operations and in some cases shut down entirely.
So what does all of this mean for broker revenues? Frost Consulting estimates there has been a 43% reduction in global commissions for equity research, which in turn has led to a 40% reduction in budgets allocated by the 600 or so firms producing equity research, from $8.2bn at their peak in 2008 to $4.8bn in 2013.
2. What would regulators like to see commission payments used for?
The UK Financial Conduct Authority (FCA) wants broker research to be treated as a cost to fund managers to be paid out of their own P&L rather than out of clients’ funds (‘unbundling’). This may eventually lead to a ‘priced’ market for investment research in which consumers (investors) only receive the products they are willing to pay for. It seems reasonable to assume that this will lead to greater personalisation, interactivity and niche focus. Such changes could offer independent and specialist firms an edge, as well as present opportunities to the long tail of companies often overlooked by sell-side analysts. In 2014 the FCA banned the use of client commission payments for corporate access in the UK, a rule which made waves in the investment community but has yet to be fully adopted or implemented.
3. Are investors paying commission responsibly?
Milton Friedman, the US economist, said that perhaps the most reckless form of spending is that which involves someone else’s money as you are “not concerned about how much it is, and not concerned about what you get”. Perhaps this thinking can be applied to commissions. Regulators feel that the amount of money allocated to (and by extension the pricing of) broker services would be somewhat different if investors had to pay for it out of their own pockets, and that more thought would go into the true value of these services. In last year’s survey by the UK CFA society, almost half of respondents agreed that investment firms in the UK do not spend their clients’ commissions as carefully as if they were their own money.
4. How do investors assess and quantify value?
Despite the ubiquity of research and corporate access services, there is no uniform pricing model and industry experts agree that it’s a tricky subject. As Matt Levine points out in his column, one of the main challenges is that equity research, at least from a regulatory point of view, is classified as material, non-public information. As such, institutions have a responsibility to distribute it ‘fairly’. Something will have to give.
Many would argue that while these services provide a broad benefit and ultimately make markets more efficient (by helping to disseminate information and underlying analysis more widely), the model only benefits a narrow segment of the market. Asset managers are investing more and more in their own in-house research teams, and in some cases in dedicated corporate access desks. Numerous independent research providers and start-ups have also entered the market to fill the gaps and propose new models. Many of them, like us, believe that technology can play a complementary role and perhaps solve one or two issues along the way.