In Europe, Unbundling Proposals Spark Anxiety, Opposition
Market participants fear unintended consequences of efforts to ban commission payments for research.
Barely a month after implementing a ban on the use of commissions to pay for corporate access, in June, the U.K.’s Financial Conduct Authority stunned the investment community by endorsing a European proposal to sharply curtail the use of trading commissions to pay for research. Stakeholders all along the financial services spectrum have been trying to gauge the likely impact ever since.
“If it happens as proposed, it means a sea change in the way markets operate,” contends Steve Kelly, who runs opinion surveys of analysts and corporate managers for Extel, a London-based data collection unit of Hong Kong’s WeConvene. Among the “unintended consequences,” as he puts it, could be substantial declines in the size and frequency of research commissions, reduced coverage and liquidity — particularly for smaller players — and an overall drop in competition. “Is that healthy for the vibrancy of capital markets?” he asks.
Others insist that this latest development is merely continuing a process that began nearly a decade ago when an FCA predecessor, the Financial Services Authority, prohibited so-called soft-dollaring — the practice of passing along unspecified research fees to investors via trading commissions bundled with execution costs — to pay for anything other than proprietary research (that is, not data terminals, news subscriptions, overhead and so on). By 2006 the U.S. Securities and Exchange Commission had followed suit, to an extent. It revised the parameters of the safe harbor provision of the Securities Exchange Act of 1934, allowing asset managers to include in their commissions only expenses that are in the best interests of the fund, narrowly defined as “advice, analyses and reports.”
Fast forward to spring of this year. The European Securities and Markets Authority issued a 349-page proposal called, collectively, the Markets in Financial Instruments Directive II (the first MiFID took effect in 2007). Its Article 23 states that research not explicitly paid for in cash is tantamount to a “receipt of inducements from third parties” — essentially a bribe — that European Union member countries should prevent.
Within weeks, France’s Association Française de la Gestion Financière, Germany’s Bundesverband Investment und Asset Management, Sweden’s Fondbolagens Förening and other industry groups objected. “If an unbundling scenario were to play itself out, we think the consequences could be quite adverse for the European fund management industry,” Philip Middleton, an analyst at Bank of America Merrill Lynch and leader of the No. 3 team in Specialty & Other Finance on the 2014 All-Europe Research Team, wrote in a June report. “Paying for research directly rather than out of dealing commissions could add approximately 7 basis points a year to the cost of managing equity mandates, we think. This in turn could equate to 30 percent to 40 percent of the profit margin from equity mandates.”
A likely result, Middleton concluded, would be to “make Europe a relatively unattractive area for asset management.” (Middleton and BofA Merrill declined further comment.)
Then the FCA endorsed MiFID II, saying in its July Discussion Paper that U.K. investment managers pay some £3 billion ($5 billion) to brokerages annually, half of which is ostensibly for research. “We have had ongoing concerns about investment managers’ controls over the use of dealing commissions and the conflicts of interest it creates for them as agents to their customers, given the lack of transparency of these costs,” the statement reads. “This is exacerbated by the largely unpriced and opaque market for research.”
Even those who agree that transparency could be improved are taking exception. “The whole idea that we are in some way inducing asset managers to behave in inappropriate ways is completely ludicrous and shows a fundamental misunderstanding of the way the equity market functions,” says one sell-sider in London, who spoke on condition of anonymity. He further calls the FCA hasty in backing ESMA’s plan before hearing from all sides involved. “It plainly admits to looking at just 17 investment managers and finding fault with only 15 of them — that’s a pretty small sample.”
The FCA said it would accept feedback through October 10. ESMA ended its open-comment period in mid-August, promising to issue a revised final version by March 2015 that will go into effect January 2017. All 28 member nations, including the U.K., must comply (and some could go even further). “This is too premature a matter to comment on,” insists Reemt Seibel, an ESMA communications officer based in Paris.
In the U.S., meanwhile, SEC communications director Gina Talamona declined comment.
But FCA chief executive Martin Wheatley did not. “Research plays a vital part in capital markets. In particular, small- and midcap companies can draw real benefits from research coverage as investors seek out stocks with long-term growth potential,” he tells Institutional Investor, to reassure market participants that their concerns haven’t fallen on deaf ears. “Given the value clients place on research, we believe they will be willing to pay for external research through the investment management fee — exactly as they pay for internal research now. Based on our own extensive work with the buy and sell sides, we believe these changes will encourage greater competition and a wider variety of services, coverage, price structures and distribution models.”
Wheatley stresses that the FCA won’t act rashly. “Our recent Discussion Paper invited feedback on the potential impact of ESMA’s proposals, which will inform the debate before the new rules are finalized by the European Commission next year,” he says. “In the interim, we do not intend to make any changes to the rules in the U.K.”
Detractors fault the FCA for rubber-stamping MiFID II and failing to stick up for U.K. interests. “FCA represents the U.K.’s view,” Wheatley responds. “We enjoy clear and constructive dialogue with ESMA, and its members, across a broad range of topics.”
Yet another criticism concerns the fact that the proposal would apply to research on all types of investments, not just equities. Since fixed-income transactions are generally paid through the spread on the instruments, not via dealing commissions, it’s not clear how regulators want this research financed. The FCA’s Discussion Paper plainly concedes, “We have not explored this issue in our current work.” Wheatley adds, “If ESMA’s proposals are implemented, then portfolio managers would need to consider how they pay for third-party nonequity research and may need to contract for this separately.”
While that might not comfort everybody, it’s important to note that neither the FCA nor ESMA is advocating an outright ban. “The proposal is for what you might describe as severe restrictions over the nature of the research services that could be purchased from dealing commissions,” stresses Daniel Godfrey, CEO of London’s Investment Management Association, an industry group. “What would be included and excluded in that is not clear.”
For instance, the proposal makes an exception for “minor nonmonetary benefits.” What exactly that means is unknown.
Some insiders do acknowledge that there are potential conflicts of interest in research procurement. “The asset manager is effectively spending somebody else’s money,” allows another London-based analyst speaking on condition of anonymity. “But the solution should be a greater use of commission-sharing arrangements, better disclosure and probably requiring research budgets and broker reviews, which the best asset managers already have.”
CSAs divide trading commissions between the firm that provides execution and the one that furnishes research advice. “The CSA is kind of a nice halfway step to where you have price discovery and a better sense of exactly how much you’re paying to whom,” says the CIO of a large U.S.-based fund management firm. “It makes you price out the different parts in what looks like hard dollars.”
To the end investor, though, the total charges come as one bundled fee — and therein lies one of the regulators’ chief complaints. “If you were designing a system from scratch, there’s no way you would let people pay for research with commissions,” asserts Michael Mayhew, CEO of Integrity Research Associates, a Darien, Connecticut–based consulting firm that reports on trends in the global investment research industry. “But that’s the way it is, and has been, and changing it raises all kinds of issues.”
The cost of recalibrating payment processes alone could be crippling. “With unbundling, it will be harder for brokers to fund large research desks,” observes Richard Small, an attorney specializing in financial regulatory matters at the London offices of Davis Polk & Wardwell. “The counterargument has been raised, however, that investors currently pay for an oversupply of research with little value and that there is a constant demand for good research.”
If asset managers have to pony up for research from their profit and loss accounts, odds are they will simply buy less of it. “That would harm both the buy side and the sell side,” says Mayhew. Independent boutiques could benefit over time, he points out, if big shops are forced to separate out their research fees as many small providers already do. “But in the short and intermediate terms, midsize and smaller firms will be hurt significantly more than the large ones, which have a more diversified revenue base and the resources to adapt,” he says.
Another question concerns the appropriate pricing of research, notes Edward Wolfe, founder of Wolfe Research, a New York–based boutique and affiliated broker-dealer. He launched the firm in April 2008, after the demise of Bear Stearns Cos., where he had been a top-ranked analyst for years. (Wolfe was voted onto the All-America Research Team 11 times between 1999 and 2008 in Airfreight & Surface Transportation and predecessor sectors, including eight appearances in first place, and has made the team five more times since then. His firm employs seven senior analysts, six of whom appear on this year’s team.) In some cases, he says, clients pay an up-front, prenegotiated quarterly amount. In others the asset manager decides at the end of the quarter how much a specific sell-side provider’s input was worth. “Their people take a vote internally,” the research director says. “Based on what percentage of the vote you garner, they award you a certain amount of money.”
Not surprisingly, this good-faith system can lead to some strife. Wolfe has been unusually public about airing grievances with fund managers he felt had made a systematic decision to pay well below the cost of production for research resources they had consumed. So if the proposals in Europe get people to talk more openly about the value of research, that could be good for firms like his.
Yet many asset managers may forgo independent providers in favor of a big-name firm that can offer access to the initial public offering calendar or other add-on services. “If they have to attribute the specific cost of research to the fund manager’s bottom line, that makes them more discriminating in terms of who they are willing to pay and how much,” says an analyst at Cornerstone Macro, a New York–based boutique. “When they pay through commissions, they tend to be very sloppy about what they’re buying.”
Of course, no one can say for sure how asset managers will react. “It’s premature to conclude that clients who obtain research already will absolutely refuse to pay for the same research in any other way than the current model,” says the IMA’s Godfrey. “If research has value, will people not pay for it?”
Similarly, it may be too soon to assert that only the biggest firms can adjust. “No one knows yet who the best adapters will be,” he adds. “I don’t think it will necessarily be only the biggest, the strongest, the fastest.”
He believes that the emphasis should be on resolving potential conflicts of interest, not harping on so-called inducements. “There needs to be a different approach,” he contends, “which would involve a thorough and objective evaluation of the possible negative consequences around price formation, liquidity, capital raising for small caps — to look at those and see whether under a different model one could maintain the benefits of the current regime but also remove or minimize conflicts that exist.”
Godfrey advocates a broad-based approach. “There are lots of pieces in the jigsaw, and you need to make sure you can rearrange them without losing some important ones on the floor without noticing,” he says.
Frédéric Surry, head of equities and convertibles at BNP Paribas Investment Partners in Paris, agrees. “The proposed regulatory changes could have serious unintended consequences for our practices and, in the end, for our clients,” he predicts. “If we have to pay for research directly, through our P&L, we are going to become more selective for sure, and our research budget will decline. That will have an impact on our long-term returns. If you have less research, you have less idea generation — and that will mean less returns for clients.”
Instead, Surry proposes a road map of common principles for tracking and evaluating research. It would include a detailed accounting of CSAs, with full disclosure and oversight. “To highlight how we value the research provided by brokers, that is very important,” he declares. “[But] research is not an inducement, as ESMA puts it. It is not a benefit to the asset manager himself — it is linked to the fund, to the strategy behind the investment process.”
He acknowledges that providing greater transparency may not be easy or come without cost. “It will mean more duties for us,” he says. Yet for Surry, research is too important to give up. “If you are based in Paris and want to cover emerging markets, say, you can’t do it alone,” he points out.
But that is precisely what Surry expects more firms will try to do. “The large asset managers that are able to maintain their own global in-house research will have a tremendous advantage,” he predicts. “Then brokers who specialize in small caps will face tremendous barriers and will not survive.”
Not everyone disagrees with ESMA and the FCA. Benn Steil, director of international economics at the Council on Foreign Relations, a foreign policy think tank headquartered in New York, argues the proposals fix a loophole in existing regulations. He believes asset managers are overpaying, which causes “a material drag” on fund holders’ returns. “If fund managers had to bear the costs themselves and then recoup them from clients transparently, the fund managers would quite naturally be far more diligent about pushing down those costs.”
Steil doesn’t expect Wall Street to change, though. “In the U.S. the current safe harbor regime is well entrenched, and many powerful vested interests are intent on keeping it that way,” he says.
Other observers see any tightening of the regulatory framework as a kind of antigrowth noose. “There are sufficient, suitable regulations in place already,” maintains Ron Geffner, a former SEC enforcement lawyer, currently director of the financial services group at New York law firm Sadis & Goldberg and a vice president of the Hedge Fund Association, an international industry trade group. “The real problem is, regulators have gotten too regulation happy.”
Investors should already understand how their commission costs are being spent, he says. “If they don’t, they aren’t properly educated or aren’t reading the documents already required,” says Geffner. No amount of disclosure will force shareholders to be well informed. Anyway, he adds, regulators already have the authority to enforce fund managers’ fiduciary obligations.
Charles Trzcinka, a former senior economist with the SEC’s Office of Economic Analysis and now a finance professor at Indiana University, Bloomington’s Kelley School of Business, goes a step further. “This is a rule that solves an imaginary problem,” he says. “Market prices will be less efficient, which will hurt every investor. If the restrictions reduce the number of analysts, which will almost surely happen, investors will definitely be worse off.”
In the coming months, in preparation, financial institutions with international operations need to consider accommodating the different regions where they operate. “Many global investment firms currently operate trading and research platforms that are fully integrated to take advantage of economies of scale, for personnel reasons, and/or for operational alignment,” explains Dan Waters, former director of conduct risk at the FSA and now a a managing director at the ICI Global division of the Investment Company Institute, a mutual fund trade association, in London. Many have incurred “substantial costs” to expand worldwide, he adds, “anticipating that the global practice of using commissions to pay for research would remain consistent cross-border.”
To break up a unified payments system will be not only complicated but expensive. “Given the global nature of much of investment management, there are many different combinations of circumstances — the clients’ jurisdictions, the investment firms’ and their affiliates’ jurisdictions, and the trading jurisdiction,” says Waters. “The adoption of different European rules would cause significant operational complexity, increased compliance burdens and costs, with significant disruption to the efficient and effective provision of research across funds and clients at a global level.”
Global firms could even find it too expensive to operate in Europe, closing the region off from international investors and vice versa. “The end result would be increased fragmentation,” he asserts.
Another collateral cost involves data management. Doug Morgan, president of institutional asset management at Wayne, Pennsylvania–based SunGard Financial Systems, says new regulations could indeed be good for his information technology business. “To the extent that these changes align with technologies we’ve developed, we could build solutions to help our customers address the new scenario,” he says.
Then again, the new rules could constrict budgets. “If you start pricing research in a more competitive open market, you may find it creates a barrier to entry within the asset management industry,” he cautions.
But the worst-case scenario seems to be the current one: the state of uncertainty. “We can only go so far in developing solutions before we’re sure where the industry requirements will ultimately land,” says Morgan.
Which raises the question: Have authorities simply not thought this thing through? “The regulators are just saying ‘transparency, transparency, transparency.’ But they’re not really focusing on what are the costs, costs, costs,” comments Mark Williams, a former bank examiner with the U.S. Federal Reserve, now a professor of finance at Boston University. “When regulators say, ‘You’ve got to account for your research spending,’ what they’re really saying is, ‘It’s going to cost you more to do business.’” • •