Commission-sharing provides halfway house

While the UK’s FSA’s rules on unbundling may not have radically reformed the trading landscape, they have subtly altered the terrain. Commission-sharing agreements have become the status quo and the remaining bulge-bracket sellside firms continue to capture the lion’s share of both execution and research business.
A split between the two activities as envisioned in the original Myners report is unlikely to happen in the current environment as fund managers do not want to dig any deeper into their own pockets. Reinder van Dijk, managing consultant at Oxera, which was commissioned by the FSA to compile a progress report on unbundling, said: “Progress has been made but it definitely has not resulted in the second big bang which many people thought would be the case when the FSA first introduced unbundling.

The use of commission-sharing agreements has risen and there is clearly a greater separation between the purchase of trade execution services and research.

“On the other hand, one interesting statistic we found in our study was that the bigger brokers are still the main providers of both research and execution. Investment managers were asked what proportion of their 10 largest research providers were also their top 10 executing brokers. The mean proportion between the two was 75 percent.”

Oxera canvassed 21 large investment managers, 11 brokers, eight retail fund providers and six pension fund trustees last August and September. Published in April, the study showed that the amount investment managers spent on bundled equity research and trading commission packages had fallen to 36 percent at the end of 2007 from 48 percent in 2006. At the same time, there was a jump in the number of commission-sharing agreements, which are designed to allow firms to choose a broker for execution and direct the research portion of the commission to another broker or independent research provider. In terms of the split between the two, commissions had remained relatively stable since unbundling: 45 percent for execution and 55 percent for research.

The popularity of commission-sharing agreements in the UK reflects the global trend, although the country has the highest penetration of such arrangements in Europe, with around 64 percent of firms using them, according to a Tabb Group report published last year. Regulators put unbundling firmly on the map in the wake of the dotcom crash amid anger over biased research that led to overinflated technology shares.

In the UK, this led to a report by Paul Myners in 2001. Five years later, the FSA launched rules on the use of dealing commissions. The aims included increasing transparency and breaking down costs to the end users as well as encouraging the use of payment mechanisms to enable services from brokers to be purchased separately.

While the industry has applauded the FSA’s efforts and the progress being made on unbundling, views are mixed as to whether commission-sharing agreements – the industry’s response – are the best solution.
One main concern is counterparty risk, especially after the demise of Lehman Brothers and Bear Stearns. There is also apprehension about leaving large CSA balances at investment banks, as there is a perception that some can drag their feet when making payments to research providers. For example, banks that remit payments only a few times a year may be carrying sizeable CSA balances that are neither segregated nor insured.

The Lehman collapse revealed that the fate of these assets is uncertain in the case of a bankruptcy. Some fund management groups, such as Scottish Widows Investment Partnership, are happy with the current state of affairs. Tony Whalley, investment director at Swip, said: “We were one of the first institutions to draw up commission-sharing agreements and it has enabled us to fully unbundle.

“We receive research from the firms we want to and not what our counterparties think we should receive. Before we unbundled, about 70 percent of our research commissions went to the large brokers and that number is now more like 60 percent, with the remainder used to pay for more niche operators who often do not offer the execution capabilities that we require.

“One of the most important points about using commission-sharing agreements is to make sure you are continually monitoring the situation to ensure that commissions and payments are broadly in line.”

Many on the sellside note that commission-sharing agreements have forced them to take a harder look at their product offering. Chris Newson, who has sat on both sides of the fence having worked at Fidelity and now as director of global commission management at Bank of America Merrill Lynch, said: “The bulge brackets have concentrated on providing an integrated service and it is not a surprise that there is a reasonable degree of correlation between those firms providing both high-quality research and execution.

The cost of boldly going…
“The benefit of commission-sharing agreements, together with broker voting, is that they make the process more transparent. They enable the buyside to compare and contrast the research providers and brokers, while allowing the brokers to address client coverage requirements and improve their services to better meet their clients’ needs.”

Steve Kelly, global head of Thomson Reuters Extel Surveys, also believes that “commission-sharing agreements have played a role in the growth of boutiques and independent houses. They have made it much more straightforward for the buyside to take research from these firms. Our studies have shown that not only is there a marked increase in the number of these firms but also they are scoring higher on fund managers’ rankings”.

However, some market participants see commission-sharing agreements as a halfway house and would instead prefer adherence to Myners’ original recommendations that stated “clients’ interests would be better served if fund managers were required to absorb the cost of commissions paid, as this would provide appropriate incentives for fund managers to manage these costs”.

Richard Balarkas, chief executive and president, Instinet Europe, said: “Commission-sharing agreements are not a satisfactory answer. I would argue that while they can facilitate the separation of a bundled commission into two separate payments – one for execution and one for research – they are insufficient to ensure true unbundling.

“What needs to happen is for the trading desk to have complete control of the broker list for execution and choice of broker for each trade. At the moment, this is not the case and the power base in many fund management groups is still the portfolio manager. They are using trading commissions to pay for non-execution services such as research, company access and initial public offerings.”

Chris Angel, a principal at Mercer Sentinel, said: “According to the Oxera report, commission-sharing agreements have achieved the transparency and separation that the FSA requires but they fall short of total unbundling. Pension funds may have a better idea of where the money is going but they now have no control.
“Also, while commission rates have fallen, it has not been that much, with the average bundled commissions still costing around 12 to 18 basis points. This suggests fund managers are still paying too much for research at the investors’ expense.”

Putting a value on research, though, has been an age-old problem for fund managers. Very often, a 30-second call from an analyst may be most valuable, while the stacks of reports that clog the inbox are worthless.
Jim Connor, director of European investment management services at Navigant Consulting, said: “It is not simple and there is no perfect model. You cannot underestimate the price that a fund manager will pay for being first in the queue for a call or to receive good quality investment ideas.

“The other factor is the increase of dark pools and where they fit in a commission-sharing agreement. I think this will eventually lead to managers re-evaluating their strategies and this could facilitate further unbundling.”
What is unlikely to happen though is that fund managers will pay for the research from their profit and loss account. Tim Tanner, equity business manager at Aviva Investors, said: “Commission-sharing agreements are just a step in the evolution of unbundling, but they are not a complete solution. The question of whether fund managers should pay from their P&L has been on the agenda for a long time and there have been several conferences on the subject. I do not see it happening in the near to medium term as it would have significant implications for a fund management company’s profitability.”

Richard Phillipson, a principal at Investit, said: “I do not see the model changing as asset owners have not applied the pressure while asset managers have so many other things to think about in this environment.
“However, I think if fund managers were paying out of their own pocket they would try to be more careful about what they spent.”

© Efinancial News 2009,


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