Regulations

Basics of MiFID II

MiFID 2 is the revised “Markets in Financial Instruments Directive”, a broad set of European financial regulations that came into effect at the start of January 2018.

The original MiFID came into force in November 2007, just before the financial crisis. Its main intentions were to foster greater integration within Europe’s financial markets and to drive down trading costs, primarily for equites. The regulations also resulted in the creation of so-called multilateral trading facilities (such as Chi-X or Turquoise), which allowed equities of listed companies to be traded for the first time on platforms independent of large national exchanges, thus introducing competition and lowering the cost of trading.

Three years after the launch of MiFID, the European Commission (the executive arm of the European Union) began work on MiFID 2. The EC was keen to develop the existing legislation to build in lessons learnt from the financial crisis and to broaden its scope to encompass other asset classes. Simply put, the goal of MiFID 2 was to provide greater protection for investors and increase transparency throughout the capital markets.

Though the regulations do not specifically address listed companies (either inside or outside the EU), they dramatically impact the prevailing investment research and corporate access models offered by investment banks to institutional investors, which has significant knock-on effects for companies globally.

Perhaps the most relevant issue for IR teams that MiFID 2 seeks to address is how asset managers pay for research on companies and meetings with management, which they use to help them make investment decisions. Until now, asset managers received research, including written reports and phone calls with analysts, for ‘free’, i.e. the cost of this service was built into trading fees, which were often paid for by the fund managers’ clients. Conferences, roadshows and investment trips worked in a similar way. For the first time, fund managers are having to budget separately for research, corporate access and trading execution (something known as ‘unbundling’).

Faced with having to pay for these services themselves for the first time, investors are already becoming more selective in terms of what they consume. While it is still too early to understand the full impact of the new regulations, early indications point to an overall reduction in traditional research coverage and an increasing reliance on buy-side analysts over sell-side analysts. On the corporate access side, a decrease in investor attendance at broker-organised conferences and company roadshows seems inevitable, as investors look for more cost-efficient ways to study companies.

MiFID 2

Main goals:

  • To make European markets more transparent and efficient;

  • To restore confidence in the capital markets following the financial crisis;

  • To move over-the-counter trading of various asset classes to established trading venues.

Coverage:

  • All 28 European Union countries;

  • A vast array of asset classes: equities, fixed income, commodities, currencies, futures, ETFs, retail products such as CFDs.

Who does it effect:

Almost everyone:

  • Companies in EU countries;

  • Companies in non-EU countries that operate in, or have investors in, the EU;

  • EU fund managers;

  • EU pension funds;

  • EU retail investors;

  • Indirectly (and to a lesser extent) fund managers in the US and Asia.

What does it mean in practice:

  • Unbundling of payments for research/corporate access from trading execution;

  • Introduction of volume caps for dark pools of equity;

  • Greater pricing transparency for OTC and off-exchange markets;

  • Tougher standards for financial and investment products.

Q&A: MiFID II and impact on Investor Relations

One of the more high profile aspects of the MiFID II legislation that came into effect across Europe last month concerns how asset managers pay for research and corporate access — two costs that were in the past, in one form or another, built into trading fees.

In this Q&A, we wanted to share some of our thoughts in response to a number of frequently asked questions we have received from our clients on this topic during the last few months. We also wanted to share a few easy-to-implement, practical tips for investor relations teams to consider going forward.

How has the market been preparing for MiFID II?

In line with its goals of greater transparency and accountability, MiFID II makes it clear that the onus is on the buy-side to pay a proper value for ‘substantive investment research’, the free provision of which would be considered an illegal ‘inducement’ to trade with a particular broker.

As such, investment managers in the EU were confronted by four key decisions in 2017:

1. How much research is worth, and how much they would be willing to pay for it.

2. What total budget they should allocate for research.

3. How this budget should be funded (i.e. whether the costs should be covered by the fund or passed on to its clients).

4. Which providers they would buy research from.

The MiFID II preparation process has had two main effects. The first is that, as a result of this ‘unbundling’ of research and trading execution fees, a new market has been created around paid investment research, with its own market-driven pricing model. The second effect is that many investors have already dramatically reduced the number of brokers from whom they purchase research, now that they cannot obtain it freely from all providers.

The same effects are apparent (with some notable differences and exceptions) for corporate access. Conference attendance, company meetings and group lunches hosted by third parties with trade execution capabilities all count as inducements, so must be paid for by investors. In practice, this means that investors are no longer able to accept company meetings from the sell-side unless either they are already clients of the organising broker, or unless they pay a separate fee, which many have expressed a reluctance to do. As with much new legislation, there are still some areas of uncertainty, for example whether it is ok for a broker to invite non-clients to a meeting at the company’s explicit instruction; some investors are choosing to err on the side of caution for now by refusing sell-side invitations where there is no existing relationship, but this question (and many others) will no doubt be ironed out during the coming months. 

What is the impact of MiFID II on investor relations teams?

While it may still be too early to draw many conclusions (and the regulations will almost certainly impact companies of different sizes and in different markets to varying degrees), two universal themes seem to be emerging:

1. Investors will be increasingly reliant on IR teams to complement their own research

The strategic importance of company investor relations teams will grow as a direct engagement model with the investment community emerges. Quality IR staff will be increasingly sought after by investors, and rewarded with greater responsibility and recognition as their efforts become more explicitly linked with the fair value of the company.

2. Companies and investors will need to fill any gaps in corporate access coverage themselves

Investment banks will continue to play an important role in providing corporate access services both to companies and investors. This being said, gaps in coverage will inevitably begin to emerge and widen, resulting in a reduction in the quantity of investor/company meetings. Both sides will need to take up the mantle and fill the gaps themselves if they want to stay on top of meeting opportunities and other relevant developments.

A recent IR Society/Quantifire survey seems to validate this. Over half of the buy-side institutions surveyed believe they will rely more on companies contacting them directly for meetings during the coming year. Some have even reached out to companies to encourage them to take a more proactive approach.

Will institutional investors build out their own corporate access capabilities?

Institutional investors are already starting to take a more consistent and structured approach to corporate access. Many are quite far along in this process and have set up their own dedicated corporate access desks to track consumption, monitor meeting opportunities and proactively manage outreach to companies throughout the year. For fund managers and analysts, corporate access extends far beyond face-to-face meetings during conferences and roadshows: it encompasses all opportunities to interact – from requesting or joining a call to discuss a change in the company’s strategy, to validating an assumption in a financial model, to attending a site visit in a remote location or requesting to join a capital market day – thus it must be measured and managed effectively.

How will the independent research model evolve?

There are two main models of independent research which both continue to grow and evolve, offering an increasingly popular alternative to traditional sell-side research.

The ‘investor pays’ model allows independent research providers to compete on the same playing field as traditional investment banks. A number of buy-side institutions have started to send out research tenders to the market (sometimes even announcing them on their websites), with anyone eligible to participate. Typically independent analysts must have enough of a focus and expertise to differentiate their offering from established sell-side players, and also to be able to provide bespoke reports on request.

The ‘company pays’ model also continues to grow and attract more interest, especially from companies who have suffered from a loss of sell-side coverage during the last few years. ‘Company pays’ research (which is typically free for investors) tends to be factual, providing an editable financial model and staying clear in most cases of recommendations. Marketplaces which aggregate research have already started to emerge, simplifying the consumption process for the fund manager.

What about consensus management?

As investment research becomes less ubiquitous, there is growing concern in the investor relations community about how consensus estimates will be managed going forward. The paucity of meaningful ‘consensus’ (analyst average) estimates could have an adverse effect on stock price volatility, something highlighted by a recent UK IR Society survey. 69% of respondents anticipate changes in how they collect consensus post MiFID II; 43% of these respondents would not be inclined to trust data from third party aggregators, with another 45% believing that small- and mid-cap companies will not have enough data points to generate any sell-side consensus at all.

Is there a role for stock exchanges to play to address some of the challenges?

There’s little doubt that up until now companies have tended to rely heavily on brokers for investor access element of their IR strategies. Although the potential void created by MiFID II will increase the pressure on companies to be more proactive, it also creates other opportunities for collaboration, which may be more healthy for the long-term growth and cohesion of the capital markets.

Exchanges in particular may be able to play a more direct role in supporting and guiding companies through the changing landscape. There are many examples of this already happening. To use emerging markets as an example, Moscow Exchange, Dubai Financial Market, Borsa Istanbul and Warsaw Stock Exchange (amongst others) already organise regular investor conferences for their listed companies in major financial centres. Exchanges throughout the EU are starting to explore new ways of forging formal and informal partnerships to ensure that research and information continue to be widely available throughout the marketplace, especially for mid- and small-cap companies.

Some exchanges have set up dedicated internal teams to continue to support companies in the weeks and months following the completion of a transaction. There are also significant opportunities for exchanges to lead discussions around independent research, consensus management, investor events, and IR advisory services. This can only be a good thing both for companies and investors.

Does Brexit impact MIFID II implementation in the UK?

The short answer is no. The UK financial regulator (the FCA) made it clear that until the UK formally withdraws from the European Union (in March 2019), existing EU laws such as MiFID I will continue to apply, and firms should continue to implement all new EU legislation such as MiFID II. It is also possible that the UK will decide to keep MiFID II legislation largely intact even after it withdraws from the EU.

Would these changes have happened without MiFID II?

MiFID II regulations have accelerated and amplified a number of underlying trends which have been developing in the capital markets for several years. These include:

  • An increase in the amount of off-exchange trading, e.g. through MTFs, dark pools and other electronic trading, which has contributed to a drop in trading revenues for the sell-side, reducing the pool for corporate access and research;

  • A decrease in the number of IPOs following the global financial crisis, placing a further strain on sell-side revenues;

  • A consequent reduction in the size and scope of analyst and sales teams as the sell-side focuses on large-caps/highly liquid companies/main index constituents;

  • A steady increase in the number of investors with global mandates, and in the number of markets opening up to foreign investors for the first time;

  • The rise in popularity of ETFs, which has led to outflows from traditional active funds and caused asset managers across the board to cut costs.

Some easy-to-implement, practical tips for IR teams

Based on our conversations with company IR teams and investors, we have tried to pick out a few best practice suggestions for companies to follow:

  • Keep track of your meetings with shareholders during the course of the year and identify shareholders with whom you have had no contact in 8–12 months. Find out if meetings with these investors can be organised by your analyst or corporate access coordinator.

  • Publish your conference participation and roadshow schedule on your IR website calendar.

  • Publish upcoming roadshow plans on the last page of your investor presentation.

  • On your IR website, clearly display the name, email address and telephone number of investor relations team members who are available to answer investor questions.

  • If feasible, add some additional individual and/or group meeting slots to your roadshows for any investors who are not included in the schedule but may still be interested in meeting you.


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 articlethat 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 Stockviewsand 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.

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

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

Soft 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

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