Unbundling Commissions from Research: Big Pain, but Any Gain?

Customers are supposed to understand and agree on exactly what they are paying for. Right.

It sounds like a truism, but it isn’t always true. Deals may contain perks or incentives that are never explicitly detailed in the agreement. If they suddenly have to be spelled out and agreed upon, item by item with the cost attached, the individual or company providing such transparency might not be too happy. Beyond opening the kimono into whether or not they are giving their customers a fair shake, their staffers will discover that agreements are going to take a lot more work and oversight.

Such is the case when it comes to the European Commission’s proposed requirement for European-domiciled asset managers to “unbundle” or separate just how much they are spending on executing an order and just how much they are spending on third-party research for each underlying fund, as discussed in a recent conference call hosted by the Security Traders Association in New York. About 211 US and overseas firms dialed into the call.

“Our members understand that global asset managers will not want to maintain two sets of policies on payments with brokers and will most likely institute one policy for all their global businesses,” says Jim Toes, president of the STA. “If this scenario plays out then changes on unbundling will come to the US.”

Depending on just how “transparent” the asset manager has already been with its clients, the reaction to change can range from wholehearted approval to resentment and even bewilderment, according to a follow-up telephone survey of ten European-based fund managers conducted by FinOps Report. All have already accepted the fact that change is coming — and as early as January 2017 — but based on the apparent dissent among European markets on the nitty-gritty of adopting the new unbundled commissions approach, the uncertainty over how any new rules will be implemented is causing asset managers plenty of angst from what they tell FinOps.

The End of CSA?

“We don’t know whether we can still use our current CSA practices or will have to abandon them altogether,” says a compliance manager at a fund management shop in the UK.

The UK’s Financial Conduct Authority (FCA) has suggested that it wants CSAs, short for commission sharing agreements, banned in favor of a new so-called research account payments. Not everyone agrees. France’s securities watchdog AMF has indicated that CSAs could be adjusted in some fashion.

Under the UK’s scenario, an asset manager would pay for research from a separate research payment account funded by research charges to the firm’s clients. “Most firms would agree that the working practicality of this is near to impossible and some have proposed subtle wording changes to the text to the EC, agreeing that budgets be planned in advance but not agreed to in writing on a per client basis to reduce the inevitable administrative burden,” says Duncan Higgins, managing director and head of electronic sales for Europe, the Middle East and Africa for agency brokerage ITG, who spoke during the STA call.”

While the conflicting viewpoints of just two of Europe’s largest regulatory agencies does put into question whether the EC will be able to work out an acceptable compromise in time to meet a 2017 implementation date, asset managers and broker-dealers are bracing themselves for change as evidenced by their questions during the STA conference call.

ESMA released its technical advice to the European Commission last December. The EC typically takes ESMA’s recommendations into consideration in coming up with a final version of any legislation to go through the European Council and Parliament. Then comes adoption by individual member states of the European Union. Some argue that, in suggesting banning CSAs, the FCA has overstepped ESMA’s technical advice or explanation of how to uncouple commission payments from research payments.

Here is how the time-honored CSA works: The asset manager charges each investment fund it oversees a bundled or combined fee for both trade execution and research. The fund manager then works out on its end how much of that money will go toward paying for trade execution and how much for research with each service provider. “Some fund managers explain the breakout of execution and research payments down to the underlying fund level ahead of time, but this more often occurs after the trade has been executed and the value of research has been established,” explains Rebecca Healey, European consultant for research firm TABB Group in London. “Sometimes, there is no breakdown at all.”

Valuing Research before the Trade

European regulators are concerned that asset owners — pension plans and others don’t understand what they are paying for and the amount of money being allocated to research on their behalf has nothing to do with the value of the research itself, but just how much volume — or number of trades– the individual fund is executing with the fund manager. “The presumption is that the greater the number of trades, the more money will be spent on research,” says Healey. “Likewise, in the bundled model, cross-subsidization may lead to some investors paying for services they didn’t use.”

The new mantra for European-domiciled asset managers following the new version of MIFID or MiFID II: pay only the true value of research and tell the individual fund what that amount is up front so it can agree in advance — meaning at the beginning of each year. Then stick to the plan. Spend no more on research for the entire year.

Such a scenario might sound reasonable, but won’t be easy for asset managers to implement for two reasons. Setting a value — or pricetag — on what research really costs will ultimately mean a lot of haggling with bulge-bracket or mega Wall Street brokerages who don’t separate the cost of trade execution from research.

Then comes explaining it to each underlying fund and getting an agreement. Getting the funds to agree to pay for research, once it’s separate contract, has been called the wild card of this scenario. It’s logical to assume that the funds may not be willing to pay for research in times of poor returns. If some funds refuse to pay for research,  some wonder if the service agreement would change for those funds.

Next up: once deciding on how much research is worth, allocating the correct amount to each underlying fund. Then getting an agreement the amount is accurate. “If it sounds like a challenge for compliance managers, it is,” explains Healey. “It means spending a lot more time talking with underlying pension plans, broker-dealers and investors.”

Of course, broker dealers aren’t exactly thrilled at the idea. “Disregarding a general uneasiness to do so, brokers will have a hard time assigning detailed value to research as this is something they never had to do,” explains Toes.

Just how much is research worth could be a matter of intense debate between the asset manager and underlying customer, particularly if the value depends on the ultimate performance of the security selected. How does someone know what that is until after the trade is actually executed, or until the asset has been held for a period of time? Then deciding on how much of the research budget to charge each client will be a tough call. Should it be pro-rated depending on the size of the overall fund or the size of the position in the particular security?

“It will come down to an an increased onus on asset managers around compliance and operations,” explains Tom Conigliaro, managing director in San Francisco for Markit, which offers commission management software.”As a result of recent ESMA proposals, European regulators will wind up shifting more of the burden to fund managers.”

Using CSA agreements, all asset managers have to do is set up a CSA account with each broker-dealer for all of its underlying fund clients.The asset manager will pay for commissions with broker-dealers out of the account. Then the asset manager will tell the broker-dealer how much to pay for research based on what is left after paying the commissions. The broker-dealer will then take the money out of the account to pay for the research.

Separating the Charges

Fast forward to the potential new rule: The asset manager might have to set up separate accounts for commissions and research with each individual fund. It will then have to pay the broker-dealer separate fees for each fund for commissions and for research. What was initially a single piggybank that could be managed by multiple brokers for multiple asset managers now turns into potentially dozens of piggybanks.

“It will become a logistical maze for asset managers to work through to establish which client should be charged for what,” says Healey. “Robust governance and disclosure requirements will need to be put into place and asset managers will have to review third party research and quality.” After all, they will need to justify the pricetag to their underlying funds.

That’s the work just on the asset manager side. “Creating policies and workflows which satisfy a more contractual process will become complicated,” says Toes. “What happens if the fund manager loses an asset or customer during the term of the agreement? In addition the sales process for negotiating a fixed dollar amount will need to be created along with processes for invoicing, collecting and reconciling changes.”

Granted, there are commission management applications such as those offered by Markit and Eze Software Group which can help out. While they will likely benefit financially from any regulatory change, they would still need to be operationally adapted to fit the new rules. “Platforms, such as ours, do help asset managers allocate commission and research payments to broker-dealers but they aren’t detailed when it comes to allocating the exact amount to each underlying fund,” explains Justin Tourtelotte, director of the consulting practice at Eze Software Group in Boston.  “However, most aren’t detailed when it comes to allocating the exact amount to each underlying fund.” Eze Software Group will be adding the extra information required by the new legislation as well as a communications tool allowing for commission approvals from each individual fund.

Given all the compliance and operational changes the new European legislation will require, will it accomplish its goal of ensuring disclosure and fairness? Maybe not, says Conigliaro. “The regulators are concerned that asset managers are not being fully transparent about how they are using client funds to pay for research.”

Such an assumption is a bit fallacious, he believes. Ultimately, says Conigliaro, asset managers won’t pay for research that can’t boost their performance so they are motivated to do the right thing and buy only the research they need. Likewise, pension plans and other asset owners have the ability to change asset managers who are not delivering results.

Of course, such a scenario presumes that the pension plan or other asset owner has a breakdown of what it is paying for commissions and what for research. And for the most part, they do. Just a few bad apples are apparently making the entire industry look bad.

Advantage to the Large

So just what will the new legislation accomplish? Perhaps it is what European regulators wanted all along. “The largest asset managers may ultimately decide to pay for research out of their own pockets and not charge underlying fund clients,” says Conigliaro.”That puts smaller asset managers at a competitive disadvantage prompting potential consolidation.”

For their part, some firms are fighting back, urging ESMA to keep the status quo and just ensure CSAs are implemented in Europe. “To experiment with an untested hard-dollar research model will most likely harm the investment industry, local economies, the growth of valuable research, and most importantly the investing public,” writes New York-based broker-dealer and CSA facilitator Westminster Research Associates in a March 2 letter to ESMA.

CSAs, argues Westminster, already provide a complete unbundling and granular accounting of the costs of both research and execution. Fund managers can pick who they want for trade execution and research while having the ability to control costs by paying brokers through a budgeted research target and then move to an execution-only rate.

In the meantime, given all the upheaval just what should European-domiciled fund managers do? Get ready for some interim change even if the final regulation has not been adopted, recommends Tourtelotte.

To that end, fund managers can start by creating detailed broker-dealer votes that accurately evaluate the value of each piece of research. They can then use the reports to share unbundled trade information with each account. “This will help with a few pieces of the puzzle, leaving us in holding pattern when it comes to the payment mechanism,” explains Tourtelotte.