Earlier today, the head of the UK’s Financial Conduct Authority (FCA) threw down the gauntlet on fund managers’ use of client commissions to pay for investment research. In a landmark speech given at an FCA conference, FCA chief executive Martin Wheatley said, “The system is not working as intended. Wider reform is now required to address these flaws that cannot simply be addressed by incremental improvements to the existing rules.”
The FCA announced it would be conducting a thematic review of commissions and will release a Consultation Paper in November which will seek industry views on how to improve the current commission regime. At the same time the FCA is engaging other European regulators through the Markets in Financial Instruments Directive (MiFID) with the goal of making reforms Europe-wide. However, citing past UK leadership in financial regulation, the FCA said it would not necessarily wait for EU adoption of commission reform.
Problems with the current system
Wheatley said that the current regulations governing asset managers’ use of client commissions was not effective: “Since 2006, supervisors have increasingly come across evidence that the current regime does not sufficiently enhance transparency and accountability. There are two persistent problems. Firstly, services are being ‘bundled’ together, with eligible and non-eligible services being mixed. Secondly, when this information is provided back to the client, there is a lack of clarity or adequate transparency around how their commissions have been spent.”
He cited examples of firms allocating a significant portion of their Bloomberg and Reuters subscriptions questioning how much of the service was legitimate research. Under the UK’s definition of research, unlike in the US, market data does not qualify as research and is not eligible for payment with commissions.
He also mentioned a firm that nearly doubled its commission payments for research because it had traded more, even though the amount of research received had remained relatively the same.
Wheatley argued that the current system increases costs for the clients of asset managers because asset managers do not control research costs with the same rigor as costs they incur directly.
He said that the link between volume of trading and research expenditure creates incentives for asset managers to spend regardless of the added value of the services.
Wheatley claimed that bundled services which combine eligible with non-eligible services cross-subsidize services that asset managers should pay for from their own funds and supports unsustainable business models that would fail under increased global competition. He said that the research market was distorted because of commissions, causing “asset managers to pay increasingly more for ‘research’ even if they receive very little value from it.”
In other words, the FCA is attacking the commission regime because of perceived structural problems: “In a nut-shell, this type of outdated bundled charging system and use of dealing commissions to purchase research lacks the transparency that has attracted a global consumer-base, distorts competition, and supports unsustainable business models.”
Wheatley also discussed corporate access at some length. The FCA estimates that approximately £500 million ($800 million) was spent in 2012 to facilitate corporate access. He cited a firm which appeared to be paying £100,000 per access.
He laid out the FCA’s position in no uncertain terms:
“We have no particular concerns with the purchase of corporate access. And we need a market for good quality research that benefits both the asset managers and their clients. But asset managers should be using their own funds if they wish to purchase access.”
He acknowledged that the Investment Management Association (IMA), the trade association for the UK asset management industry, has supported the FCA’s position on corporate access, but added, “This recognition will also need to extend to the sell-side providers of these services.”
The FCA will engage other European regulators on commission reform through the MiFID: “In principle, we support an approach that applies across Europe so if the end destination becomes un-bundling for example, then this would apply unilaterally across asset management in Europe.”
However, the FCA will not wait for an EU result before instituting reforms in the UK: “Reputationally, there is too much at stake to just wait for a European solution. We’ve led the way internationally through our ability to change, innovate and adapt to new trends and practices.”
In the short term, the FCA will be vigorously reviewing current practices: “we will be applying our new judgment-based supervisory model and consulting on changes to clarify aspects of the 2006 regime in the short term.”
The first step will be a thematic review following up on the FCA’s conflicts of interest findings from last year, focusing primarily on commissions. The FCA will also be examining the sell side: “We will look at both buy-side and sell-side practices in this area as part of our examination of bundled brokerage arrangements.”
The next step will be a Consultation Paper in November which will seek industry views on how to improve the current system. The FCA will focus on providing clarity around its definition of ‘research’ and what it considers eligible and non-eligible goods and services paid through clients’ commissions.
The IMA is well aware that commissions are a front-burner issue for the FCA, having appointed a blue-ribbon panel on the topic in July. The panel was tasked with producing a report in November, but IMA chief executive Daniel Godfrey said in a statement: “The IMA has been conducting a significant review of this market for some months and we expect to be able to report our conclusions early in the New Year.” It appears the report timetable has been pushed back, perhaps as a result of Wheatley’s speech.
Godfrey also sounded a note of caution in response the speech. He was quoted as saying: “This is a very complex issue with a significant international dimension and the possibility for negative unintended consequences for both customers and the industry. It is important we take a measured and detailed approach to these reforms.”
Wheatley’s speech was powerful on a few levels. First, it revealed a deep level of passion on this topic. The predecessor to the FCA, the Financial Services Authority, had effectively washed its hands on the topic. This is clearly not the case for the FCA, especially since its chief seems personally committed to commission reform. Short of a major FCA reorganization, some level of change seems inevitable.
Second, the speech was sophisticated in its engagement of asset management industry. It was delivered at a conference for asset managers organized by the FCA. Wheatley lauded the industry for its responsiveness to the FSA’s conflict review published at the end of last year. He acknowledged the importance of the asset management industry to the UK economy. The iron fist was gloved in velvet.
Most impressively, Wheatley framed commission reform as something that would help UK industry competiveness, an apparent attempt to co-opt the industry’s main argument against reform. The speech suggests that he is well aware of the main obstacle to unbundling, which is the risk of assets being offshored from the UK.
However, Wheatley’s discussion of creating a level regulatory playing field in Europe only partially addresses the offshoring risk. Most UK managers have the wherewithal to shift research and trading to New York or Hong Kong, which are already more competitive venues than continental Europe. Unbundling in the UK would create a very unlevel playing field for UK managers versus their American cousins. There is little if any evidence that the SEC will be taking up commission reform anytime soon.
Wheatley faces another major hurdle to unbundling, which are the investment banks. His speech refers to engaging the sell-side, which has been frustrated by a lack of engagement from the FCA on the topic up until now. So far so good, but his vision of “unsustainable business models” perfectly describes sell-side research in an unbundled world. UK-based investment banks will not warmly embrace losing $5 billion in research-related commissions (estimate provided by Frost Consulting).
Nevertheless, his speech is a strong opening to a lengthy negotiation with industry participants. Some observers we’ve spoken with have suggested that the end result will be a negotiated cap on research spending, with the understanding that research commissions will not increase even if market trading increases. Whatever the outcome, some level of reform appears likely, which will present challenges to all those in the research industry which rely on commission payments.
The full text of Martin Wheatley’s speech, titled ‘Shaping the Future of Asset Management’, is provided below:
It is a pleasure to welcome you all here today to talk to you about UK asset management – about the leading international role of our sector. A leading role achieved through an ability to adapt, grow and perform through a challenging past decade. A leading role that strives to attract a global consumer base founded on confidence that investments are managed safely.
This is a critical period for the industry. A crossroads if you like; with international competition placing increasing pressure on London and the UK. I want to make the point today that if we want the UK asset management industry to remain strong, we need to look at the challenges facing the sector. We need to identify the best way to build upon success.
So today we ask some challenging questions. Today we ask: are we internationally competitive? Are charges and fees transparent? Are there inherent conflicts within the system? Today we start a debate to address these questions and identify a collective answer.
It’s this final point that I want to echo throughout the day and over the coming year. We have collectively created an environment where asset managers and their clients mutually benefit. And it’s for this reason, and this reason alone, that we need to collectively respond to these challenges so that we can continue to drive forward our competitive edge.
How the sector has grown and modernised
The UK asset management industry has grown exponentially in stature and influence over the last 50 years. The sector has transformed in a number of ways: new technologies, new ways of doing business, resulting in new levels of performance.
The most significant change has been a new level of global connectedness that has linked the UK to an international client base. This change has been particularly significant over the past decade where we have consolidated our global position by developing home-grown funds and welcoming foreign firms.
We’ve seen a dramatic change in the way the sector has performed as a profit centre, becoming a driving component of the UK’s economy. The sector has gone from managing funds equivalent to 1% of GDP in 1960 to 40% of GDP in 2010. UK fund managers were responsible for a record £5.4 trillion in funds at the end of 2012, up 6.5% on the previous year. Even through the 2008 financial crisis, the health and performance of the sector remained strong. You know all this.
You also know that the sector hasn’t just achieved this status by sheer coincidence. The sector has achieved this by its ability to innovate, change and adapt to the new global environment.
Significantly, much of this growth has taken place during a period shaped and defined by international efforts to build public trust, confidence and quality of service. We know from recent studies that the prime determinant of investor satisfaction remains quality of service.
If investors develop fears over charging, or lose confidence in asset management firms, they can and will look for solutions elsewhere. In the UK, North America, Europe, the Middle East, and Asia, strides have been taken to help ensure the industry provides value for money, and is also open-handed and transparent in supporting clients.
We differ from the asset management sectors in other countries, as nearly 50% of clients in UK asset management are made of pension and insurance funds. This places a greater onus on us to remember where the money originates, and never forget that the sector must always act as agents of clients.
So we have to ask: has all of this change been to the benefit of customers? Has the purpose of an asset manager to offer a transparent balance of risk and reward changed? Is there more that we can do to compete for investors based on enhanced customer-focus?
Emerging challenges in the sector
These kinds of direct challenges led us to take a long, hard look at how the sector is currently operating and where the reputation of the sector could be strengthened. Primarily by focusing on how dealing commission is being used and if transparency could be improved, if value for money for customers could be improved.
Ongoing issues around transparency in this sector are nothing new. In 2003 the FSA looked at the array of services that could be supplied to asset managers by brokers in return for clients’ dealing commission.
The FSA found commission was being used in a way that gave rise to significant conflicts of interest by influencing where asset managers directed trades. There were also concerns over accountability to clients and how their commissions were effectively being spent.
At the time dealing commission was used to fund a broad range of services, such as investment research, market data service licences, phone lines, seminars, external publications and data price feeds.
As a result, in 2006 the FSA introduced a new regime that worked with industry to tackle these shortcomings. The FSA had considered more radical reforms, but as a compromise, the FSA understood an alternative model devised by industry may provide a cost-efficient way of securing the same outcome.
The regime, which is still in place today, is principles based, allowing asset managers to make reasonable judgements when using client commissions.
The rules specify that, in addition to the actual transactional costs linked to execution, commissions can only be used to purchase a narrowly defined range of execution or third party research services. There is also an obligation on asset managers to disclose the use of commissions to their clients.
The FSA committed to keep the regime under review, and to consider the case for further intervention if changes did not address the original problems.
Since 2006, supervisors have increasingly come across evidence that the current regime does not sufficiently enhance transparency and accountability. There are two persistent problems. Firstly, services are being ‘bundled’ together, with eligible and non-eligible services being mixed.
Secondly, when this information is provided back to the client, there is a lack of clarity or adequate transparency around how their commissions have been spent.
Examples of this poor practice include firms allocating significant sums of their Bloomberg and Reuters subscriptions, not all of which could be justified as viable research. Or a firm we looked at that paid nearly double the amount of commission it had paid for research than the year previously, simply because it had traded more year-on-year. The amount of research received, however, had remained relatively the same.
Of most concern is that firms are pushing the definition of ‘research’ by using client commissions to cover non-eligible costs and services.
This includes a significant chunk of clients’ commission being paid for ‘corporate access’ services from investment banks and brokers. We estimate that anything up to £500 million of dealing commission was spent in 2012 to facilitate corporate access.
As an example, last year we discovered a firm that was rewarding brokers predominantly based on the corporate access they provided. This averaged out to each individual investment manager paying over £100,000 just to gain access to the management of companies they wanted to invest in.
We believe this is just one area where firms are allocating commission to ineligible services and paying more for services than they would if they had to pay for them out of their own money.
This practice transfers the firm’s costs onto the client, which clearly works against the client’s interests. This raises a concern because asset managers do not control these costs with the same rigour as costs they incur directly. These costs are indirectly borne by the client and do not affect the manager’s profits. Likewise, on the other side of the transaction, chief executives and investor relations officers have learned, sometimes to their surprise, that their time is being billed to the industry by brokers.
As a result of these findings, industry members and representatives, including the Investment Management Association (IMA), have recognised that certain practices need to change. This recognition will also need to extend to the sell-side providers of these services.
But let me be clear, we accept that investors want to engage with the businesses they invest in and practise good corporate stewardship. We have no particular concerns with the purchase of corporate access. And we need a market for good quality research that benefits both the asset managers and their clients. But asset managers should be using their own funds if they wish to purchase access.
The prevalence of bundled services, combining eligible with non-eligible services, can also disguise overpayments for eligible services. This cross-subsidises services that asset managers should pay for from their own funds. And, in turn, it sustains business models that would quickly fail under increased global competition.
Besides, the link between volume of trading and research expenditure appears to be flawed. It creates ‘pots’ of research commissions the fund manager is then incentivised to spend regardless of the added value of the services. This creates a potential conflict of interest.
And we are not seeing great value in regards to domestic competition either. Investment banks appear to sell or provide additional services such as corporate access to the highest bidder. This favours high degrees of trading. This also distorts the market and causes asset managers to pay increasingly more for ‘research’ even if they receive very little value from it.
In a nut-shell, this type of outdated bundled charging system and use of dealing commissions to purchase research lacks the transparency that has attracted a global consumer-base, distorts competition, and supports unsustainable business models.
As mentioned, the FSA committed to keep the regime under review if it failed to address shortcomings it was designed to tackle. We have now reached a point, evidenced by our supervisory work where we need to think again. The system is not working as intended. Wider reform is now required to address these flaws that cannot simply be addressed by incremental improvements to the existing rules.
There are obviously two sides to the dealing commission coin and, for these issues to be tackled effectively, to reach consensus it will also need to include the sell side.
How we propose to work together to address these issues
And that is where the debate starts. We need to be confident that managers are putting their clients’ value for money, good returns, and transparency at the heart of how they do business. Then the discussion is about how best to get there – is evolution enough or do we collectively need to be more revolutionary?
We clearly need to continue to engage at a European level on this debate. The changing EU regime is in development and we have engaged and influenced the Markets in Financial Instruments Directive (MiFID) for example from the outset. We can’t be the lone voice, the IMA is heavily involved and as an industry and we need you to engage.
Any solution has to apply the new regulatory framework. But most importantly, a solution driven by strong industry representation and informed by its expertise will benefit everyone.
I’ve mentioned MiFID, this is our main vehicle through which to negotiate. In principle, we support an approach that applies across Europe so if the end destination becomes un-bundling for example, then this would apply unilaterally across asset management in Europe.
The advantage of progressing this at European level is that it will ensure a level playing-field and allow firms to adapt their business models as implementation is unlikely to occur before 2016. We see this as an essential long-term solution to remedy this issue, which isn’t by any means a UK-specific problem.
However, the outcome of EU negotiations is still very much open. As this continues to unfold we remain open to considering all options that could achieve comparable improvements to transparency, efficiency and competition for research.
But is this enough? Reputationally, there is too much at stake to just wait for a European solution. We’ve led the way internationally through our ability to change, innovate and adapt to new trends and practices.
So today we open a domestic debate on the need to reform the use of dealing regime, particularly the use of dealing commissions, and how industry practice can be improved now to the benefit of all.
Therefore, the second strand starts here at home. Alongside the longer-term EU debate, we will be applying our new judgement-based supervisory model and consulting on changes to clarify aspects of the 2006 regime in the short term.
As part of opening this debate, we want to make sure we are predictable and provide you with a clear flight-path to how we are going to engage with you over the coming months. The first significant step will be a thematic review following up on our conflicts of interest findings from last year, using dealing commission as an example of how firms have responded to our concerns. We will look at both buy-side and sell-side practices in this area as part of our examination of bundled brokerage arrangements.
This will be followed by a Consultation Paper in November which will seek your views on how to improve the current regime. Specifically we will focus on providing clarity around how we define ‘research’ and what we consider is eligible and non-eligible when purchasing goods and services from clients’ dealing commissions.
I think it’s obvious from what I’ve said, that I believe we must work together; we need your engagement and input. We need industry feedback so that we provide clear regulatory expectations that help firms make the right judgements in the shorter term.
I am confident that we will work collectively to find a solution. Since releasing our findings on conflicts of interest last year, practices have improved in this area and senior executives really got engaged to improve the sector.
There were very few complaints or evidence of foot dragging, but rather a real determination to fix this to benefit the sector. The industry has proven its willingness to tackle challenging issues in the past; this whole debate is about becoming an industry fit for the future, and I’m sure you would share my expectation that you are part of the constructive solution.
I have confidence that we can find a collective solution and that is why I am delighted to invite the chief executive of the Investment Management Association, Daniel Godfrey to the stage.
We consider the IMA’s own review of this market valuable and welcome both the collaborative approach and the consumer orientated position that the IMA has taken. We understand that their review has led to interesting conclusions, and we look forward to hearing what these are from Daniel in a few moments.
But most importantly, I consider there to be a common interest in tackling the challenges before us, not just in Europe, but in the short-term here domestically, so we can continue to trade on our reputation of being reliable and transparent.