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.

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