2016 Global Trends in IR

BNY Mellon Depositary Receipts group has very recently published their annual report on global trends in investor relations. With 550 companies surveyed from 54 countries, it is probably the most comprehensive barometer of the current themes in our industry. The report provides large amount of comparative information on how listed companies are adapting to the changing marketing condition, touching on topics such as budgets, allocation of management’s time for buy side meetings, reporting lines, use of sell-side, measuring team effectiveness as well as insights into evolving areas such outreach to ESG investors and the use of technology.

Firstly as a qualifier, lets consider the demand side dynamics for global issuers. Despite the inevitable short and medium term swings in investor appetite for a given asset class, market or industry evidence that investors all around the world are diversifying and are increasingly adding a global component to their portfolios. Our own analysis point to over 4,000 institutional investors who hold emerging market securities, versus only 400 in early 20oo’s. BNY Mellon’s own estimates point to number of investors that hold DRs (or, roughly translated as those with global mandates) has increased from from 3,261 in 2Q10 to 4,533 in 2Q15. This figure will, we believe,  continue to grow, and present opportunities in areas where a- investors previously held most domestic bias and b- have considerable assets under management in active management and c- see diversification opportunities globally.

With this backdrop, a couple of things to note from the survey:

  • IR teams are working harder to address the growing global investment opportunity.  This is evidenced by 1- investor meetings taken by C-suite executives and IROs inside and outside their home markets have increased by 12.6% compared to 2013 (from 250.6 meetings in 2013 to 282.3 meetings in 2015). 2- companies almost doubling their IR budget allocation to travel, from 12.8% in 2013 to 24.3% in 2015, which in turn is interesting to contrast with the slight decrease in companies holding analyst/investor days (63% to 59%).
  • Top 10 sources of new investor demand in five years time, according to surveyed companies, will split evenly between emerging and frontier market. US, UK, China, Germany and Singapore lead the pact.
  • Technology tools, such as  conference call/webinar and video conference calls has been increasingly used in toolkit of a global IR officer (72% in 2015 vs. 63% in 2013 and 41% in 2015 vs. 34% in 2013). With the management and IR team time relatively fixed, and the buyside universe expanding – there is no element of a doubt that tools that help reach new investors can increase reach and efficiency, at a fraction of a price. We are strong advocates of using new tools to tell a company story . Can any one see how virtual reality or 360 videos can be applicable to the world of investor relations?
  • Despite the wave of regulations on how investors will pay for research and cooperate access, brokers continue to dominate the company non-deal roadshows arena, however with some signs of this changing. 10% of companies have organised NDRs themselves, up from 5% the previous year. Interestingly, companies rely a lot less on brokers nowadays to provide them with post meeting feedback, and rate quality targeting and introductions at upmost importance.
  • Growing ESG focus – The survey notes that there has been a strong increase (from 37% to 46%) in companies who have strategies in place to communicate with key investors on corporate governance issues on a regular basis, with top issues addressed being Board composition (76%), Transparency and disclosure (71%) and Remuneration (60%). Despite that the actual number of investors who reach out to ESG focused investors is still low (30%), however likely to rise. There is evidence to suggest that institutional investors are increasingly committing to ESG-focused principles in their strategies — whether that be through a more active engagement as shareholders or divestment strategies. 

Source: BNY Mellon Depositary Receipts Market Review 2015, BNY Mellon Global Trends in Investor Relations 2015

Equity Research Worth Paying For : A Look at Economic, Digital and Regulatory Changes

This is a guest summary post by Alphametry CEO Fabrice Bouland, of a recent senior executive roundtable about the future of equity research. You can download the full whitepaper version here.

An industry in trouble?

  • Global investment banks have seen shrinking revenues and in turn have been allocating increasingly smaller budgets to equity research. Several external factors affect revenues, among them:
  • Lower trading volumes caused by post-financial crisis industry deleveraging;
  • Fierce competition from electronic trading automation;
  • The rise of passive investing with exchange-traded funds (ETF) products rather than direct equity ownership;

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  • At the same time, supply issues such as mid and small-cap stocks poorly covered are adding a layer of complexity to the agenda.
  • The market as a whole is also very opaque in terms of pricing and service levels.
  • The delivery of content is about to radically change. The bulge bracket investment banks are starting to move towards digitization.

SAVING EQUITY RESEARCH

  • Regulators are pushing for research spending transparency on several key areas, including:
  • Price disclosure;
  • Approved budget and reporting;
  • Forecasts of how much research to spend; and
  • Assessment of investment value versus spending.
  • Since its introduction in 2007, the use of commission sharing agreements or CSAs has gradually expanded as a tool of choice for asset managers to access independent research.
  • On the regulator’s side, it is UK’s Financial Conduct Authority (FCA) that is taking the lead on the unbundling efforts while others, like the French Authorities AMF continue its support of CSAs, only advocating to add more transparency measures.

” There is strong evidence to suggest the current model of using dealing commission to pay for research reduces transparency and creates a link between research spend and trading volume, without a clear assessment of the value this offers to investors”  – Martin Wheatley, Former CEO of the FCA, who stepped down July 2015

  • To replace CSAs, the FCA wants to implement the new Research Payment Account (RPA) scheme and will ban inducements.

THE PRICE OF EQUITY RESEARCH

  • Separating research from execution raises a simple question that will be exceedingly hard to answer: how much is research worth? In a survey from a Bloomberg Institutional Equities Event, respondents were asked what factors were the biggest challenges when valuing equity research:
  • 37% said transparency was the biggest challenge;
  • 25% said ‘a la carte’ pricing;
  • 21% pointed to pricing benchmarks;
  • 10% said disparate evaluation; and
  • 7% said regulatory clarity.
  • Pricing equity research was a hot topic in the Alphametry roundtable. Participants noted that as there have never been internal benchmarks for evaluating equity research and that the range of pricing will probably be very wide.
  • Are current investment research prices fair? Sentiments from the sell-side in the roundtable leaned towards a “name your price” approach. Some participants were interested in exploring commission-based models with various level of service.

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  • Similar sectors like digital news media are changing their entire business models because content that was once paid is now free.
  • Another factor that plays into pricing is content longevity or shelf life. Roundtable participants pointed out that some content such as sector reports could be relevant for months.

INVESTMENT RESEARCH 3.0: AN INDUSTRY REBORN

  • Regulation is converging and investment firms are building global compliance platforms applying best local practices.
  • Research is going through its digital transition phase. As more content becomes digital, the industry is focusing less on the velocity of data and more on how large datasets can be analyzed.
  • Data volume is rising exponentially. Social data, web site usage, physical surveillance (e.g. shopping center parking spaces), and connected object will all be taken into account.
  • The industry is facing its largest organizational restructuring challenge ever in building up staff experience on the technology stack and using analytics to understand clients better.
  • Distribution platforms are playing larger roles and platforms that can deliver fully digital content with integration and interactivity have the upper hand.
  • All information-intensive industries such the media will be re-intermediated.

PARTICIPANTS

BNP Paribas, Citigroup Global Markets Asia, CIMB Securities, CLSA, Deutsche Bank EFA, Global Equity Flow, IBT, Morningstar Asia, Nomura International, Société Générale, Shenwan Hongyuan Research, UBS

To gain deeper insights of equity research digital trends and emerging economic models, download here your free copy of Alphametry roundtable whitepaper.

Research Regulations: the Quest for Clarity

More than 200 investment professionals gathered last month at the Institute of Directors (IoD) in London for a series of panel discussions on investment research, and how it should be provided and paid for. With corporate access now formally ‘unbundled’ from trading execution services in the UK (meaning fund managers must pay brokers to organise meetings with company management separately and out of their own pockets), the focus has shifted to research, which the FCA decided not to touch the first time around.

CSAs (commission sharing agreements) already exist to keep fees for execution separate from fees for other services such as research and corporate access, although the precise value of each remains somewhat unclear. Now faced with the prospect of potentially having to pay for all research themselves, rather than passing the cost on to their end clients, fund managers (and regulators) are taking more of an interest than ever in its cost and value.

At the IoD there appeared to be broad (although not unanimous) consensus that ‘something needs to be done’ to resolve the cost/value question, although there was some difference of opinion on exactly what and how.

What is wrong with the current research model?

Regulatory scrutiny is centring on:

  • the use of research as an ‘inducement’ (so investors will execute trades with the broker publishing the report)
  • the fact that the current model discourages competition
  • the lack of transparency around both cost and benefit

The FCA’s main goal is to ensure a fairer, more competitive, more efficient market. The key to this is transparency. CSAs were introduced to bring greater clarity to the whole commission payment structure, although the feeling is that they actually tend to muddy the waters, encouraging brokers to juggle commission between services to ‘reverse engineer’ fees.

Thus one of the regulators’ top priorities is to cut the strings that are attached to ‘free’ research and encourage greater competition for individual sell-side services.

How much should investors pay for research?

On the face of it, imposing arbitrary prices on research reports would seem to make little sense and in any case is almost certainly beyond the remit of regulators. The popular view seems to be to let the market decide.

Most investors agree that the aim of regulation in this case should be deregulation: once you remove all barriers to transparency and competition, the free market will determine the price through simple supply and demand economics.

In most cases it is still the end users who are paying for research and other services (through trading commissions), although making fund managers cover these expenses out of their own pockets should help to close the gap between price and value and stem the tide of ubiquitous ‘free’ research.

How is research currently consumed?

The vast majority of institutional investors undertake a quarterly voting process to evaluate and rank the quality of the sell-side research offered by the various providers. Once rankings are determined, budget is allocated accordingly (different services carry different weights).

Investors also rely to a varying extent on their own research and more often than not, on the sea of reports which are available either from one of the major data providers or through analyst connections. Many supplement ‘bundled’ sell-side research with reports from trusted, independent providers. When the budget is spent, they go ‘execution-only’.

The potential rule changes are forcing investors to think long and hard about what they actually need and whether the research they currently consume is worth what they might have to pay for it. As a result, fund managers are being encouraged by their firms to use whatever tools are at their disposal to more closely monitor consumption and assess value.

In recent years there has also been a growing tendency for buy-side firms to bolster their own in-house research capabilities, thereby reducing their reliance on potentially expensive sell-side services. This of course requires time, money and expertise, but the potential benefit for individual firms in cultivating their own proprietary investment ‘edge’ is obvious.

How would rule changes affect the market?

Opinion seems to be divided on how potential changes would affect the market. Below are some of the main advantages and disadvantages to unbundling research raised at the conference:

Potential advantages

  • Execution services would move more freely
  • Research would become more specialised
  • Independent research firms would benefit from a level playing field (one attendee suggested consumption may triple from its current level of 8% per firm)
  • Similarly, sell-side firms who produce research reports in markets where they do not execute trades (e.g. Standard Chartered in Russia) would not be unfairly excluded
  • A growing culture of in-house buy-side research would help to differentiate firms

Potential disadvantages

  • There may be a reduction in the depth and breadth of sell-side research
  • Small- and mid-size firms may be excluded from sell-side research distribution
  • Boutique sell-side firms may lose out

These discussions are likely to continue until the respective regulatory bodies can provide some clear guidelines on rule changes and timescales. Many at the IoD expressed growing frustration that, having taken the lead on this issue, the FCA seems now to have backed away; the recently announced delay of MiFID II has also left a number of important questions unanswered.

Some are putting their faith in the market to resolve these questions, the idea being that if a large minority of asset managers lead the way then the rest of the market will follow. There are already signs that this process is underway, with a number of firms reaching into their own pockets to cover not only corporate access, but also research. One of the more interesting quotes of the day came from a fund manager who said “If there is a distribution platform that works, research will unbundle itself”. Healthy markets have always been founded on efficiency.

The need for change is apparent, and now finally it seems the appetite is too. Hopefully 2016 will bring a new sense of purpose and clarity to an issue which continues to create uncertainty for investors, brokers and companies alike.

What does this mean for company IR teams?

Should the regulators decide to fully unbundle research, there would likely be a decrease in the amount of sell-side reports written and distributed, particularly on non-blue chip companies, as analysts begin to take a more focused, tailored approach. Investors would be forced to rely more on their own in-house capabilities and on information directly from the company. In both cases the role of investor relations takes on extra importance as fund managers are less willing to invest their own money in the expertise of brokers.

The likely growth in buy-side consumption of independent research would present an increasingly attractive option to companies looking to reach a wider audience of investors. There would be an opportunity for technology start-ups to follow in the footsteps of companies like Stockviews and SeekingAlpha to fill the gap left by free, ubiquitous, one-size-fits-all sell-side research.

As discussed above, regulatory changes are still some way off, so the best thing IR teams can do at this stage is to stay on top of developments and maintain best practice IR, strengthening connections with both sell-side and buy-side.

Investment Research: To Free or Not to Free?

Last week we published a blog in which we attempted to get to grips with some of the important questions that remain around the unbundling of commission for corporate access and trade execution. A Bloomberg article that came out around the same time entitled “Wall Street cracks down on free sharing of analyst notes” leads us nicely to the remaining piece of the unbundling puzzle, namely investment research.

The main objectives of the ongoing regulatory scrutiny of both research and corporate access are to eliminate conflicts of interest, increase market transparency and level the playing field. To this end, the revised rules on corporate access are fairly simple: if fund managers want their broker to put them in front of companies, they must pay for it out of their own, and not their clients’ pockets.

Research looks to be heading down a similar path. If, as expected, regulators demand that investors who wish to continue benefiting from broker research must pay an upfront, out-of-pocket yearly fee (which is not linked to trading volume or value), there are 4 possible outcomes:

  1.   Brokers will continue to fund research as a loss leader
  2.   Fund managers will fund research
  3.   Companies will fund research
  4.   Investors increasingly conduct and rely on their own research (in 2014 in-house buy-side research increased by 42%)

In reality, all of these things may happen to some extent. In 2000 the US SEC passed Regulation Fair Disclosure (Reg FD) requiring publicly traded companies to disclose material information to all investors at the same time, meaning in theory analysts are free to conduct and disseminate research to whomever they please. In the case of large companies, banks will almost certainly continue to pay as they chase business from companies as well as from investors. But this does raise certain issues.

As the Bloomberg article outlines, the main problem with expecting fund managers to pay for research themselves (besides the fact that they have been passing all costs on to their own clients for years) is that research reports are widely available online or from colleagues or contacts in the industry, free of charge. The sell-side switch away from “blasting out everything it produces” will take time, although it seems that technology will play an important role in restricting access and tracking readership.

One of ESMA’s criticisms of the current model is that buy-side firms are using their clients’ money to pay for research as part of an existing commission arrangement (meaning they basically get the service for free), effectively shutting independent providers out of the market. The regulatory amendments and the likely collapse of the current model should open the door wider for independent research providers, including some of those we highlighted in our previous blog with innovative models such as Stockviews and SeekingAlpha.

The other likely consequence of limited distribution of research reports will be for analysts to adopt a more tailored, targeted approach. This could be crucial for an industry which is often slow to adopt new practices and technology. It is often the cheaper, more agile, independent providers who are quickest and best placed to respond to technology-oriented opportunities in the market, although as the article highlights, it seems that the big banks are already starting to cotton on to the competitive benefits of this approach.

What impact will this have on company IR teams?

A more specialised, less generic focus will surely bode well for companies across the board but perhaps especially for SMEs and those in emerging markets, who have historically tended to be lost in the sea of free blue chip research reports. Former NIRI national board chair Brad Allen, writing for IR Magazine, advises company IROs of all shapes and sizes to strive to be “the go-to source not just on your company but also on your industry”, rather than relying on analysts and databases to tell the story.

The reality is that while the unbundling of corporate access and research services remains a hot topic in Europe and beyond, it will be a while before legislation is formalised now that MiFID II itself has been delayed. Even in the UK there is a definite air of ‘business as usual’ as brokers, analysts and fund managers wait to see who flinches first.

In the meantime, IROs would surely do well to heed Allen’s advice. In emerging markets especially, a proactive and innovative, technology-friendly approach will help them to address the far more immediate concern of an increasingly jittery investment community. Good IR alone will probably not be enough to stem the current flow of capital out of EMs, but companies who tackle this issue head on now will be well placed to capitalise when the tide finally turns.

Unbundling: 4 questions to consider

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.

Saudi Arabia to Open its Equity Market to Direct Foreign Investment

         Saudi Arabian banknotes & coinsAfter a number of years in the making, the Saudi Arabia authorities finally announced last week that Qualified Foreign Institutions (QFIs) will be allowed to invest in shares listed on the Tadawul starting from June 15th, 2015. While foreign investors have been able to invest in Saudi Arabia since 2008, this has been limited to ETFs, swaps and P-notes, none of which allow direct ownership of the underlying equity. Opening the market to QFIs as a first step is a tried and tested approach in emerging markets (e.g. China in 2002, India in 1992, Taiwan in 1991). Institutional investors who do not meet the criteria for investing directly will likely continue to use the existing products mentioned above.

The Tadawul is the Middle East’s largest and most liquid market, and effectively the largest closed emerging market today. The 165+ listed companies have a combined market capitalisation of over $550bn, with petrochemicals and financials industries the dominant sectors. Recent IPOs have added more consumer and non-cyclicals to the market. A number of commentators are speculating that Saudi Arabia could receive an emerging market classification from index provider MSCI within the next two years, which is in turn likely to drive additional investor interest. MSCI’s Sebastien Lieblich was quoted last year as saying that if Saudi Arabia were added to the Emerging Markets Index it would constitute around 4 per cent of the total market, similar to Mexico and Russia. This development would mean that Saudi Arabia could make it into the top 10 rank of EMs as classified by the MSCI (see graph below).

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The Kingdom presents investors with a unique set of dynamics. Its economy has gone from strength to strength in recent years as it has benefited from high oil prices and output, strong private sector activity, increased government spending, and the implementation of a number of domestic reform initiatives. Rising oil prices and oil production have also resulted in large external and fiscal surpluses, and government debt has declined to almost zero. With a population of over 30 million, over half of whom are under 25 years old, it is the region’s youngest and most populous nation. Of course, there are risks. First, the Kingdom’s dependence on oil revenue (over 90 percent of fiscal revenues and 80 percent of export revenues come from the sale of oil) leaves it hostage to fluctuating oil prices, as have been seen since the summer of 2014. Geopolitical tensions in the region further added to such worries.  As with all emerging markets, there have been some corporate governance-shaped bumps in the road, however the opening of the market to foreign investors will undoubtedly help smooth the path to transparency and benefit companies and investors alike.

Sources: International Monetary Fund, Bloomberg, Morgan Stanley, MSCI

A Brief History of Dealing Commission

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.


Fixed Commissions

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

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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.

1990s

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

Screen Shot 2015-04-15 at 16.24.29Soft Commission Arrangement vs. Bundled Model

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

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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:

‘The Myners Report’

Museum of American Finance: Original Buttonwood Agreement 

OXERA’s “An Assessment of Soft Commission Arrangements and Bundled Brokerage Services in the UK”

FCA’s Consultation Paper : CP 13/17 Use of dealing commission

FCA’s Consultation Paper 176: Bundled Brokerage and Soft Commission Arrangements

Ashurst’ “New regime for the use of dealing commissions – impact on managers and brokers” 

Ashurts’ “Softing and bundling – where are we now?”

Ashurts’ “Dealing Commission: A History”

Investment Management Association: The Use of Dealing Commission to Purchase Research

Frost Consulting