If you only have the time to learn one fact about the unbundling of soft commissions, it should be this: it hasn’t taken place yet. The new rules introduced by the UK’s Financial Services Authority (FSA), which came into full force at the end of June, do not signal the death knell of the bundled brokerage fees charged by sell-side firms to the buy side. They simply require fund managers to fully disclose to their clients the split between ‘execution’ and ‘research’ costs in the commissions they pay to sell-side brokerage firms.
As David Cliffe, a spokesperson for the FSA, puts it: ‘We’re trying to get away from the use of the terms ‘bundling’ and ‘softing’ because we’re really talking about how commission is spent. What our rules have done is say you can use commission to pay for services but they have to be directly related to either execution or research.’ However, this apparently tame measure is likely to change the relationships between companies, the sell side and fund management firms profoundly – not just in the UK, but around the world.
The bundling of several services provided to fund managers (including research, trading execution and corporate access) into one commission payment to investment banks proved mutually convenient for a long time. The banks were spared from having to price their individual products, and the buy side didn’t have to go to the trouble of breaking down the various costs it was passing on to clients.
But in a controversial move, the FSA decided this arrangement was an example of ‘market failure’ for two main reasons. Firstly, buy-side clients were not deemed to be getting good value or ‘best execution’, and secondly, the market for equity research was seen as being unfairly tilted against independent research houses that don’t supply brokerage services.
Disclosure shakedown
Across the Atlantic, the SEC has been paying close attention. Following talks with the FSA, it approved new guidelines on the use of soft dollars in mid-July. The rules will limit the range of services that fund managers can purchase using soft commission to ‘advice, analyses and reports.’ Citing examples of soft dollar arrangements being used to pay for carpeting, membership fees and even entertainment or travel expenses, SEC chairman Christopher Cox explained that it was now necessary to ensure that the use of soft dollars was more clearly circumscribed.
‘Money managers have an obligation to use soft dollars to obtain real brokerage and research services for the benefit of investors who entrust money to them,’ Cox was reported as saying by Bloomberg.
Even though both the FSA and the SEC have fallen some way short of outlawing the use of soft commissions, this latest spate of trans- Atlantic regulatory action is bound to set alarm bells ringing at sell-side firms that are still suffering the aftermath of the 2003 global settlement that separated banking and research revenue streams. Simply put, if there is better transparency about the price of sell-side research, the buy side will likely be more selective in choosing what it purchases.
‘This is an extremely important development,’ explains John Barrass, who heads up the CFA Centre for Financial Market Integrity in London. ‘It will lead to a reduction in unwanted and perhaps unfocused, subsidized sell-side research and an increase in focus by the buy side on what the research market actually is. The buy side will probably increase its work in this area, which will create a more competitive playing field for independent research houses and force the sell-side research people inside the investment banks to improve in order to ensure their quality is up to the mark.’
While it will take time for these changes to take effect, the equity research market may look very different in the future. Stephen Parker is the chairman of Rontech, a London-based firm that provides fund managers with software to help work out the respective costs of trading and research. He thinks the buy side is becoming more adept at deciphering the value of research and will eventually be more discerning about how it spends its money.
‘The buy side will probably be spending money with different brokers on different products and services because, for the first time, they can see what things implicitly cost,’ he says.
In the driver’s seat
Outside the UK, voluntary unbundling is already taking place. Last October, US mutual fund giant Fidelity Investments begin separating its research and execution payments to Lehman Brothers; it has since done the same with Deutsche Bank. Both sell-side firms have now arrived at similar arrangements with half a dozen of their clients, reports Michael Mayhew, CEO of Integrity Research Associates. He believes that over 90 percent of asset managers in the US want to follow the UK disclosure model. Most fund management firms are somewhat reluctant to talk publicly about what they consider to
be commercially sensitive information, however.
Gunnar Miller, who runs the 30-person in-house European research team at RCM, part of Allianz Global Investors, is one of the few who is outspoken about the subject. ‘We pay hard dollars out of our own pocket for our own research,’ he says. ‘If you have an in-house research department, unbundling counts double because you really have to explain to your clients why you’re effectively paying for research twice. But you can’t cover the whole world, and clearly there are going to be elements you need to outsource.’
A recent study by Tabb Group suggests the appetite for sell-side research will wane in the coming years. It predicts that spending on sell-side research by US and UK buy-side institutions will fall from $5.6 bn this year to $4.25 bn by the end of 2008. At the same time, spending on internal research is forecast to rise from $7.68 bn to $7.91 bn and spending on independent research is predicted to climb from $1.49 bn to $1.78 bn.
Miller thinks unbundling will lead to a closer and more direct relationship between companies and the buy side. ‘Most larger money management houses have the ability to pick up the telephone and say, We own 10 percent of your company; come on down, we want to talk to you about this,’ he says.
Where next?
With the buy side taking more research in-house and commissioning more from independents, the future for sell-side research isn’t looking all that rosy. Tabb Group predicts the number of sell-side analysts will fall from about 9,300 today to just 6,000 by 2008.
It would be foolish for anyone to write off banking research just yet, says Parker, a former analyst with UBS. ‘To talk of the death of the sell side is absurd,’ he asserts. ‘If unbundling achieves the elimination of things that are unwanted but have previously been paid for, that’s a good thing – and I’m sure the sell side recognizes this, because it means improved profitability for them.’
Meanwhile, the investment banks have been trying to work out new revenue models for research funding. New business from hedge funds is helping. For instance, retired Niri president Lou Thompson has quoted Dennis Shea, head of global research at Morgan Stanley, as saying that 40 percent of his firm’s research funding comes from hedge funds. As well as servicing hedge funds, some see an expanded role for the sell side in providing traditional fund managers with corporate access. Mayhew remains skeptical, however: ‘What’s hilarious to me is that what most buy-side firms are paying the sell side for is corporate access,’ he says. ‘But the sell side is being very short-sighted because I cannot believe that a buy-side firm is always going to pay the sell side for access. Over time, you develop your own relationship, so the buy side won’t need to pay the sell side for corporate access; they’ll get it themselves.’
