As both buy-side and sell-side get to grips with the demands of the regulators on both sides of the Atlantic for greater transparency in commission spending, The TRADE asks if an industry standard is likely to emerge.

Richard Schwartz

From 1 January 2006, the UK Financial Services Authority's (FSA) rules on soft commission and bundled brokerage will kick in. Even those asset managers who have avoided softing will be affected by the new disclosure requirements set out in Policy 05/9.

The rules limit the use of dealing commission to payment for execution and research. Investment managers will have to disclose to their customers the details of their spending on each. Following a six-month transition period, existing soft commission arrangements will be removed from the FSA rulebook.

The underlying principles of the new regime have been broadly welcomed by buy-side and sell-side alike on both sides of the pond. 'Unbundling won't be good for everyone, but it does assist the identification of the value proposition of the different services that a buyside firm acquires,' comments Marcus Hooper, responsible for global connectivity at Bear Stearns.

One way that fund managers and brokers are looking to deal with the new rules is by establishing commission- sharing agreements (CSAs). The FSA's view is that such arrangements are 'not inappropriate', provided there is full disclosure and the client selects the third party research services to be paid for out of commission spend.While hardly a ringing endorsement, the FSA's position is being viewed by the industry as a green light to promote CSAs.

The SEC, while not aligning itself entirely with the FSA position, appears to be narrowing the discrepancies with its UK counterpart. 'You're seeing regulatory convergence from a public policy perspective,' says John Meserve, president, Westminster Research, a Bank of New York subsidiary that provides commission management services. 'The first point to note is that commissions can be applied to acquire research. The use of client commissions to acquire independent analysis and tools that support the process has been preserved, both in London and in the US.'

Mark Denny, head of equity dealing, Investec Asset Management, agrees. 'I don't think the SEC and FSA are miles apart on unbundling principles,' he says. 'In any case, we always take the strictest line on any ruling. Particularly where firms have a presence in both areas, they're going to have to do the same.'

Meserve, based in New York, is particularly complimentary about the FSA's approach. 'I think the FSA should really be applauded for what they've done, which is to define a commission as execution and research and to give people a set of standards to apply around it,' he says. The SEC has traditionally taken a somewhat different approach, he notes. In the UK, there was a specific provision for soft commission arrangements. 'The term 'soft dollars' never had a legal standing in the US,' he comments. The 28(e) Safe Harbour clause, which has applied since the 1930s, allowed firms to pay above the lowest commission in return for a bundle of services, but these other services have not been discretely priced.

The FSA's position on what constitutes execution and research is set out in Policy Document 05/9 (see box). As to what counts for research in the US, says Meserve, the SEC is continuing with the standard that has applied since the interpretive release of 1986. This is effectively information, research, and analysis that aids in the investment decision- making process. 'They have, however, acknowledged that times have changed and that maybe some of the tools that were once determined to be research shouldn't be any longer because they have become ubiquitous,' he explains. They have therefore eliminated products such as T1 lines and dedicated PCs that do not have a component of intellectual thought. 'That's a very tiny part of what people pay for with commissions,' says Meserve. 'There's really been an urban myth around that.' Interestingly, says Meserve, the SEC preserved the ability to use commissions to pay for periodicals and conferences, unlike the FSA, but in their broad sweep, the two regulators are heading in the same direction.

IMA disclosure
Much of groundwork for the new UK regulatory regime was in fact laid by the market itself through the Investment Management Association (IMA). The IMA represents the UK-based investment management industry and includes independent fund managers, the investment arms of retail banks, life insurers, investment banks and the managers of occupational pension schemes among its members.

Together with the National Association of Pension Funds (NAPF), the London Investment Banking Association, and the Financial Services Authority (FSA), the IMA spent two years working on a market solution in the UK to the disclosure of softing and bundling arrangements between fund managers and brokers. This to some extent explains the FSA's principles-based approach, which put the onus on fund managers to justify their use of commission spend to their clients.

It is the IMA's disclosure framework (see box) that Meserve regards as the major innovation in commission handling. 'Never before did you have to be so explicit in what you were paying in commission and where it was going,' he comments. 'This disclosure is now going to be given by the UK managers to their US and Asian clients voluntarily. So all of a sudden, if I'm the New York State Teachers Fund, I'm going to say, 'This is pretty interesting. This UK manager is doing a breakdown of my international portfolio.' They're going to ask their US managers for the same thing.' The transparency train, says Meserve, has left the station. 'Once the SEC gets to grips with this, it will really change the world of sell-side research in the US.'

Commission sharing
For Meserve, commission sharing offers a logical path both to compliance with the spirit of the regulations and the practical aim of maximising client benefit. 'What London is doing in that regard is fabulous, because it's on a clean sheet of paper, it allows managers to trade where they want to get best execution and use the client commission to pay whoever is adding value in the research process without a lot of strings attached,' he says. 'In the US, it hasn't had such a formal mandate, but the idea of being able to trade where you want and pay for other research is exploding.' A much discussed deal between Lehman Brothers and Fidelity in the US, setting a fixed annual fee for research and a separate basis point commission rate for execution has given a further boost to the idea of discretely priced research in the US and appears to leapfrog regulatory demands.

Beyond soft commissions
If the essence of commission sharing is to get brokers to write cheques to third parties selected by the asset manager, control of these arrangements would need to rest with the buy-side firm to abide by the spirit of the FSA rules. How different will such an approach be to existing soft commissions? 'It all depends how you operated your softing arrangements,' explains Mark Harding, head trader at Invesco Perpetual. 'We have a tight process around softing with a committee that meets monthly to review our arrangements. I envisage that we'll have a brokerage committee under the new regime. I don't see CSAs as a major new departure.' The main distinction with existing arrangements, he suggests, is that some currently softable services will not be permissible.

Investec's Denny takes a similar view. 'It's not a bad thing, from our point of view,' he comments. 'We will be entering into commission sharing arrangements with various brokers - perhaps no more than three or four. As far as the products and services we will pay for using that system, they're not going to be hugely different from what we currently do.' Investec already uses research from boutique research houses that have no execution facility, Denny points out. 'All we're going to do is ensure that we're very clear about the definition of payment to that provider.'

CSAs are nevertheless still largely a result of bilateral efforts and there is no industry standard yet on how they should be structured and administered. It is also not clear that a common understanding exists within each firm as to what the limits of such agreements are. 'Everyone is doing considerable work internally and as a community, the buy-side has been involved through the IMA,' says Harding. 'My perception is that within each firm there are some people with a good understanding of what is required to comply, but that knowledge has not yet spread to the entire sales force.'At Invesco Perpetual, he adds, a project team draws on compliance, ops, analysts and execution experts to ensure common understanding.

Interest in CSAs extends to continental markets, especially in the light of the forthcoming MiFID requirements to demonstrate achievement of best execution. 'In France, we're developing a similar process to what the UK is planning to implement in January,' says Bernard Coupez, head of broker relations, BNP Paribas Asset Management and president of SFAF, the French industry association for financial analysts. 'The French regulator published a report in July which included a recommendation for CSAs. At this stage we are discussing how to implement that among professional bodies.'

Much of that discussion revolves around the need for standardisation, says Coupez. 'One of the questions is how to standardise and clear the information, the budget and the accounts relating to CSAs,' he observes. It's not simply a question of the split between research and execution. 'It's important to reconcile the figures on a regular basis to be sure that everyone receives the cheque they expect,' he comments. 'At the moment, firms are developing their own approach, but what happens, for example, when brokers find they have to exchange cheques with each other'?

Admin headache?
As far as the administrative burden of managing CSAs is concerned, this can be handled in different ways. 'A centralised service may well be attractive as managing and reconciling commission arrangements across, say, 12 brokers could be tedious and time consuming,' observes John Barker, managing director, Liquidnet Europe, which is implementing CSAs with a number of its users, the first batch of which should be in place by end-December.

For Harding, the attraction of a centralised service would depend on the number of CSAs that a firm wanted to implement. 'We plan to have five or six CSAs at the outset,' he says. 'If we open up more, we'll look at services like Westminster.'

One issue would be the cost of using such a service and how such costs could be offset. The bigger a firm's broker list, the more attractive it becomes. 'The Westminster model allows you to trade across 35 broker/ dealers to generate your commissions to pay for 28(e) or third party services,' says Meserve, 'so we're paying for Reuters/Bloomberg tools, we're paying for independent research boutiques as well as what we call non-core brokers who are not necessarily giving you capital, but have smart analysts covering regional or small cap stocks.'

Hooper at Bear Stearns is, however, adamant, that CSAs can be easily administered with simple tools. 'If an asset manager is setting up a CSA programme, I see no reason why they should have to pay extra to a broker for that service,' he insists. 'We give our customers a CSA payment scheduler which allows them to keep track of their commission spend and calculate the required CSA payments.'

Investec plans to start small and manage its own CSAs. 'I don't see this being complicated,' says Denny. 'We may, for example, ask Citigroup to write a cheque out to a boutique research house.We will determine the value of that research service. We will segregate the commission sharing account with Citigroup so that I will be clear how much money is in the pot and so will the broker.' That account will be segregated from the firm's execution and research relationship with Citigroup itself. 'The feedback I'm getting from the sell-side is that different clients want their CSAs managed in different ways,' says Denny. In addition, he notes, different OMS handle commission splits in their own way. 'It's a lot to do with IT as well,' he adds.

Broker lists
Will the advent of CSAs inevitably lead to a contraction in broker lists? Not necessarily. 'We don't see this as an opportunity to cut our broker list,' stresses Harding. 'Those offering CSAs tend to be the large brokers with prop desks, but best execution often dictates that we use local brokers for some transactions.' In the longer term, however, he expects the list will reduce naturally. At the same time, he says, 'we already use certain third party independent research-only houses and we would expect to incorporate these into our CSAs.'

Denny is similarly unlikely to pare down Investec's broker list to any great extent. 'There are probably no more than one or two brokers that we are actually going to stop trading with and just give them a research cheque,' he says. 'There may, for example, be a regional broker in the US that provides a very good research product. While their execution is probably as good as the next man, from a risk perspective, we may as well trade with a larger broker and have a CSA cheque sent out for the research.'

With a range of specialist products, Denny adds, 'it is important for us to maintain trading relationships with some of these niche firms as well. I think it would be quite dangerous for us if we slashed the smaller brokers on the trading side.'

Internal tensions
Once CSAs are in place and operating, will portfolio managers and traders within a buy-side firm automatically agree on how the commission should be split and spent. Here, there may still be issues to work through. 'There is a natural tension in paying for different services from the same commission pot,' says Hooper, 'but handling this efficiently puts the buy-side trader more in control of order flow.' Coupez sees the informal process that currently prevails - whereby fund managers, indicate to their traders which brokers' research they value - as a first step. Players will then progressively decide more precisely the appropriate price for each service. 'In the past you sometimes had a contradiction between quality of execution and quality of other services provided by the broker,' he comments. 'A more transparent process will reduce conflict of interest.'

The future of research
Opinions differ on whether execution or research stands to gain more as a discretely priced service in an unbundled environment. Joe Gawronski, COO, Rosenblatt Securities, an execution-only agency broker headquartered next to the NYSE, expects research to be squeezed. 'If you look at what people are paying in the US for execution- only products, it's around 2 cents a share,' he observes. 'If they're doing it themselves through DMA or algorithms, they're looking at more like a penny a share. There are big stat arbs that are paying much less; there are smaller shops that are paying more.'Assuming an average full-service commission rate of 4-5 cents, Gawronski argues, that would suggest that half of that figure is attributed to services other than execution. Citing the Fidelity/Lehman deal, he points out that if, as has been reported, Fidelity is paying Lehman only $7 million a year for research, 'they would appear to be taking a hit on the research side.'

The distinction between what counts as execution and what as research is not always as clear as might be expected, however, particularly between different markets. 'A little of what is included in execution in the UK, would, in the US, be regarded as research, such as an institutional salesman providing market colour, saying, 'Hold on here, because we think the stock is going to trend down,' says Meserve. 'One thing that's for certain is that alpha-generating unique content will not go to zero.' Ideas are not free. 'If you drive the commission rate down, you're not going to get the first call,' he adds. 'If you really want the service, you're going to have to pay for it. One trend I'm seeing, therefore, is the use of more and more electronic venues to generate research commissions.'

While Gawronski sees the overall research pie shrinking, he does hold out some hope for independent providers. 'In a way, it may be easier for the independents, because if everyone has to be written a cheque, then you're comparing their research with a bulge-bracket firm's research and it's apples to apples.'

Meserve sees larger firms reassessing their provision of research services as a result. 'I wouldn't be surprised to see one of the big bulgebracket firms exit the provision of research to institutions,' he says, 'even if they retain their research capability for proprietary trading or investment banking.'

The nature of the research offering is also likely to change as pricing becomes more transparent. 'In Europe, you have up to now seen a 'push' process, where the brokers would push their research to the PMs who were inundated,' says Coupez. 'Commission sharing will create a 'pull' and will increase the quality. The buyside will become proactive.'

With fund managers now having to justify their research spend to the end user, Coupez predicts that research could well become more customised. 'Today, even if you are a priority customer, you simply get standard reports ahead of others,' he contends. 'Tomorrow, you may be able to request research to be undertaken on a specific sector.'

The pricing of research will take time to play out. 'We have all been receiving services other than execution from our brokers,' says Coupez. 'Are these services valuable in themselves or are they simply marketing tools? That is the real question.' Individual firms will, he suggests, have to develop an internal process to determine the value of research - a task of which most firms should be quite capable. 'There are yardsticks,' he points out. 'After all, when you employ a new analyst in-house, you have a view of the value you expect them to bring.' At the end of the process, says Coupez, 'we expect a decrease in the quantity of research and an increase in the quality.'

Meserve, meanwhile, is keenly following the development of the 'paid-for' research space. 'Companies have historically been desperate to get coverage,' he notes. 'The idea would be that they could go into a blind pool and pay for some research companies to cover them. They'll have no say in the selection of analysts or in the recommendations, but they will get coverage.

As some of today's uncertainties are clarified, other tensions are bound to arise. 'I think more of an issue in the future will be the question of cross-subsidies between large and small firms,' suggests Hooper. 'To what extent will the now transparent research spend of the big firms be going to allow smaller firms to benefit from the same research for much lower cost'? No one expects the approach to unbundled spend on execution and research to follow a clearly determined path. The broad direction, however, seems set.