New York, NY – The current structure of U.S. Client Commission Arrangements threatens several aspects of the current environment for third-party brokerage, independent research, and the use of institutional clients’ brokerage commission dollars.
The following post was written by Mr. William George, long-time reader of Integrity’s ResearchWatch blog and commentator on the financial services, investment research, and soft dollar businesses.
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(1) There seems to be a general opinion that bulge bracket, or full-service brokers uniquely provide best execution. I don’t believe this generalization is supported by trading cost studies.(a) The assumption that bulge bracket and full-service brokers (uniquely) provide best execution implies that as commission sharing arrangements evolve, advisors seeking best execution will focus their order flow on a small number of very large (and powerful) broker /dealers.
(2) Historically, independently produced research has competed with bulge bracket, and full-service brokers’ research. Independent research has provided independent opinions on investments when analysts at bulge bracket and full-service (investment banking) brokerage firms have become over zealous or when they produced research influenced by conflicting interests. Allowing bulge bracket full- service firms to be at the nexus of the receipt and allocation of research commission expenditures puts them in a position of controlling the revenue stream of their competitors; it might be compared to letting the fox into the hen house.
(3) Bulge bracket and full-service brokerage firms have resisted all attempts to require disclosure, transparency and the pricing of the proprietary services they provide. Without disclosure, transparency and pricing of proprietary services, third party research will be competing for its share of the commission allocation against an unknown abstraction (bundled proprietary services). There is no reason to believe the bulge bracket and full-service brokerage firms will fairly compensate sources of independent research that might frustrate their optimistic analysis, sometimes conflicted research, and lucrative marketing efforts.
(4) Investment advisors go to great lengths to prevent “leakage” of investment strategies, information sources, and research ideas. Holding such information confidential allows them to work their investment strategies and take advantage of their research discoveries. In the anticipated environment, with commission sharing arrangements consolidating order flow, the reduction in the number of trading venues and the concentration of the research payment process will give large brokerage firms special insight into trading strategies and research resources of investment advisors. It will also give a few large brokerage firms special insight into the pricing / cost of third party research. By observing commission payment information and trading information these few large brokerage firms will discover very rapidly “the what and when” about research effectiveness.(b)
(5) Under the recently released SEC “No Action Letter” (requested by Goldman Sachs)(c) it appears that research ‘producers’ need not be registered, or meet any other specific qualifications or requirements to act as research “providers”. Payments will be made at the request of investment advisors and brokers will bear no liability. In the past, third party brokers have provided marketing assistance to research providers and have offered valuable insights (to research providers and to advisors) into regulatory issues surrounding research provision under Section 28(e) and ERISA. Allowing unregistered individuals to “direct” and receive payments for “research” will introduce a host of unintended consequences, generate more opportunities for conflicts of interests and fraud, and increase the costs of oversight and discovery.
Footnotes:
(a) EDHEC Transaction Cost Survey / Study
http://www.edhec-risk.com/latest_news/Business%20_Strategy_Issues/RISKArticle.2007-01-16.2316?newsletter=yes
(b) Concerns about special insights into competitors’ business Lisa Shallet, CEO of Sanford Bernstein
http://www.researchconnect.com/current_comments_detail/cc_922.asp
(c) No Action request and response letters
http://www.sec.gov/divisions/marketreg/mr-noaction/2007/goldmansachs011707-15a.pdf
also see, SEC Request For Rulemaking file #4-531 February 10, 2007 at:
http://www.sec.gov/rules/petitions/2007/petn4-531.pdf