Commission Unbundling to Drive Asset Manager Shakeout

By Rebecca Healey, TABB Group

Originally published on TABB Forum

The UK Financial Conduct Authority has continued its relentless pressure on asset managers to come clean about the hidden fees and charges in dealing commissions. But while the transparency resulting from unbundling research and execution may benefit the industry in the long term, changing the payment-for-research structure will guarantee continued consolidation of the asset management industry, creating new challenges for investors.

Opacity and confusion over financial services costs and fees have convinced some regulators and market participants that the use of dealing commissions to purchase research is fatally flawed. In fact, buy-side trading desks have been slowly realigning internal processes to meet regulators’ requirements to unbundle the cost of research from the cost of execution. While the speed and depth of change may not exactly be in line with the FCA’s expectations, 58% of European firms now have a research budget in place, and 55% intend to switch to execution-only commissions when the budget has been reached.

And unbundling no longer is the domain of just the UK in Europe. The reality is that dealing commissions is yet another area of financial services where the global industry is undergoing painful metamorphosis. Constrained resources and greater accountability already have created demand for an improved understanding of costs versus profitability. The sell side is becoming more selective of what it provides, while the buy side has become more discerning about what it chooses to consume and how to pay for it. Seventy-nine percent of participants in the annual EU equity trading survey now use Commission Sharing Agreements (CSAs) to manage this process.

Rather than this standing as a resounding endorsement of the FCA’s lead in pushing for greater unbundling, however, greater confusion is setting in. Not every European regulator has interpreted the latest ESMA text in the same manner as the FCA, and European MEP’s are of the view that research payments were not part of ESMA’s remit. As a result, 30% of all firms are now halting the rollout of unbundling processes until there is greater clarity as to whether CSAs will be admissible in the final text from the European Commission.

An Inconvenient Truth

Paying for research from the bottom line would, on the face of it, appear to be a cleaner and more efficient payment structure. Using a bundled commission model, fund managers may or may not receive best execution if they automatically route orders to favored providers of research. Cross subsidization among funds and firms may lead to end investors paying for services they did not use. However, the alternative unbundled model is not without its complications.

If small and large asset managersare to pay equally for research – that is, for research to be paid for via a flat fee – smaller asset managers will be worse off, as the cost of paying directly for research will have a disproportionate impact on their P&L; larger asset managers have greater scale with which to absorb research costs. If the research is subsidized in favor of smaller asset managers, however, this would unfairly penalize larger asset managers.

Further, use of CSAs may penalize existing clients of the funds; if research is purchased earlier in the year and then the firm switches to execution-only commissions for the remainder of the year, any new clients in effect receive the research for “free.” However, if CSAs are no longer admissible as per the FCA’s recent indications, 100% of smaller asset managers believe they will be negatively impacted; 79% of mid-tier and 75% of larger asset managers also believe smaller firms will be negatively impacted. In this competitive environment, where few can afford to increase their fees, should market forces then dictate the outcome?

Small European brokers also are likely to suffer. A decrease in consumed research will lead to a decline in investment in research provisions, which will lead to a fall in revenue, which will in turn make the provision of research an expense few can afford. Unattractive sectors may also suffer. We have already witnessed the widespread closure of small-cap execution desks. Few global investment banks will be motivated to carry out research on SME firms given the lack of profitability; if research is not produced, funds will also be less likely to invest in these firms. The contra argument is that this opens up the market to competition from more bespoke research providers and sector specialists facilitating a flight to quality.

But it is not only about the research itself. Other important considerations remain. If research payments are unbundled from commissions, the buy side may have to foot a potential Value Added Tax (VAT) bill, negating any potential savings from supposed misspent funds. And complex management of commission allocation payments to end funds will require in-depth technological solutions to solve new administrative headaches.

Keep CSAs in any form and it will still be too easy for less well-intentioned asset managers to fake unbundling, and that is why the nuclear option of asset managers paying for all research from the bottom line is being proposed. It is easy to spot what is wrong with the current system; but it is far harder to determine what would be a good alternative to establish who pays for what and how.

Without an explicit link to the underlying end client, it is difficult to envisage how firms can avoid passive funds paying for active managers’ research. Should there be a distinction? Is the true cost of passive research versus active research more or less than the other? And if you are paying for research “ex ante,” how do you know it is “good” research in advance? You can only really know after the event. Yet to drill down to the individual client level will ensure firms incur huge administration costs from RPAs across literally hundreds of clients.

Anti-Competitive Side-Effects?

While the need for greater transparency is one side of the debate, eliminating the ability of firms to compete is the other. The provision of research already is undergoing subtle shifts that, like a snowball, have the potential to turn into an avalanche. As the sell side starts to cut off clients from access to research, difficult decisions will become more commonplace. If research providers are ranked in the Top 5, but are only being paid Top 10 rates, competitive questions will have to be asked.

As research content shifts from PDF documents to the Internet and becomes more accessible and searchable, asset managers are likely to pick and choose niche services and providers as and when they require them. Fintech will deliver new solutions that will revolutionize how research is delivered and consumed in a similar manner to how Google and Apple have transformed how information is accessed. As we become more reliant on technology for efficiency and cost control, the added value will increasingly come from the skill of the analysts’ interpretation.

While larger asset managers are able to make the requisite investment in technology, smaller boutique players will need to rely on third-party relationships and technology to bridge the gap.

A Third Way

The use of dealing commissions does not have to be fatally flawed. Mandated CSAs, budgets and robust payment structures could provide the necessary transparency and increased competition in the research market that the regulators seek. There are those that believe CSAs can never work, given the lack of industry progress so far. There may be holes in the wall, but surely it is better to identify and fix the holes than smash the wall down in its entirety?

Transparency may benefit the industry overall in the long term; but changing the payment-for-research structure will guarantee one thing: continued consolidation of the asset management industry. Unwittingly, this will create new alternative challenges. Larger order sizes will create growing liquidity issues as fund managers retrench their portfolio coverage to an ever decreasing circle of assets. As instruments become harder to trade and harder to source, firms will increasingly have to turn to technology to deliver best execution.

The industry now needs to step up and demonstrate to the regulators that commissions can be managed fairly – or put up with being regulated into submission. The time for standing on the sidelines is over. With the asset management industry continuing to consolidate and operate on a global basis, these changes will resonate beyond Europe, as firms adopt common systems globally to reduce business complexity.