The following is a guest article provided by Neil Scarth of London-based Frost Consulting, which also includes Susan E. Walton, who among many accomplishments has helped Integrity increase its European presence. Neil is a veteran observer of the research scene, having most recently been a hedge fund portfolio manager at Deephaven Capital International and Trilogy Global Advisors as well as previously running ABN Amro’s sell-side European equity business in North America.
The Financial Services Authority’s (FSA’s) initiative to unbundle execution and non-execution commissions in the UK has been an unqualified success – at least in terms of adoption. Frost Consulting estimates that over 70% of UK commissions now flow through these structures. The UK, with the world’s highest Commission Sharing Arrangement (CSA) penetration rates, has become the “benchmark” market for unbundled commissions globally. The UK experience may provide insights and lessons for less unbundled markets.
The best intentions of regulators frequently have unanticipated consequences. The CSA is no exception. While the FSA established a clear principle for unbundling, it did not provide an operational blueprint for actually implementing this significant change. This was left to the industry to figure out. Faced with the new regulatory requirement, most asset managers had to cobble together middle office systems to attempt to administer their CSAs. These often bespoke, excel-based systems were used to estimate CSA balances held with brokers net of the effect of instructing the CSA execution broker to make payments to third parties.
The operational complexity of these sets of non-standardized bilateral relationships increased with the number of CSA execution counter-parties. In 2007 Frost estimates that average UK asset manager had 7 CSA execution brokers, primarily from the Bulge Bracket. As commissions flowing via CSAs grew, so did the number of CSA executing brokers. In 2008 the average asset manager had 12 CSA execution relationships. This expanded dramatically in the wake of the Lehman bankruptcy which trapped millions of pounds of asset manager and plan sponsor commissions. The post-Lehman counter-party risk diversification panic saw some managers retaining in excess of 25 CSA execution brokers. At least some of these were mid-sized firms that had little interest in becoming CSA execution brokers for fear of diluting their high margin bundled business. Under pressure from large asset managers many reluctantly agreed – but few had the operational capability to manage the process. Consider the following:
CSA Payment Mechanism Schematic
Typically, CSA execution brokers pay in excess of 10 third party providers each. Consequently, the audit trail, (if it exists) would have to reconcile the constantly changing commission balance in the asset managers “CSA pot” held by the broker, adjusted for potentially hundreds of third-party payments. If the forgoing schematic had 25 CSA execution brokers the scale of the operational challenge would be obvious. Frost Consulting estimates that in 2009 nearly $5 trillion in equity principal value representing nearly 400 million (one-sided) trades flowed through European CSAs. There is no central clearing mechanism for the CSA market.
The unspoken truth regarding the evolution of CSAs in the UK is the lack of administrative clarity in the research payment process. As the number of CSA execution counter-parties per asset manager has grown, the result has been “spreadsheet chaos”. The rapid growth of the CSA market has overwhelmed the industry’s collective capacity to manage this process. The opaque nature of current CSA payment and audit practices (in aggregate) represent a significant financial and fiduciary risk for all CSA market participants and their clients. For asset managers, a key risk may be that the level of regulatory and plan sponsor scrutiny regarding the CSA payment mechanisms, currently minimal, may increase significantly with little warning. One high profile “commission accident” of an asset manager not being able to document where allocated CSA commissions actually ended up, could change the regulatory environment quickly.
Frost Consulting is aware of several instances in which commissions did end up in unintended places. Understandably, this is not widely discussed. The bulge bracket bank with a seven figure client CSA commission balance which never receives third party payment instructions gratefully concludes that this was to compensate it for its own research. The operations department of an asset manager that has lost track of CSA commissions is unlikely to broadcast this fact to management, the media or the regulators. This should be a concern to plan sponsors, whose money it ultimately is.
Frost Consulting recently met with the FSA who appeared largely unaware of the scale of the problem – but certainly not disinterested in the consequences of their unbundling mandate. A recent high profile FSA initiative involves ensuring that brokers segregate “client money” – i.e. funds belonging to the asset managers. Last Friday JP Morgan was fined a record £33,000,000 for failing to do this. [Editor’s note: The fine, announced June 3rd, was for a failure by JPMorgan Securities Ltd to separate overnight customer accounts in its futures and options business during 2002 and 2003. Click here for details.] The magnitude of the fine is indicative of the importance FSA attaches to protecting “client money”. In a less than subtle warning to the industry, the regulator noted that several similar enforcement actions were in the pipeline. The obvious parallel for asset managers is that commissions are monies that technically belong to their clients.
Significant legal/regulatory risks may lurk in areas that are now lightly regulated but likely require greater oversight. Regulators are at their most dangerous when regulating in retrospect. Against this backdrop, the risks of being behind the risk curve (and its likely trajectory), far outweigh the costs of being ahead of it. Historically, most asset managers and plan sponsors merely reacted to regulatory change rather than anticipating it. Perhaps the prospect of the most sweeping global overhaul of financial services regulation in almost a century might argue for a shift in approach. Even apparently minor (internal) regulatory breaches can have real world economic consequences as Gartmore recently discovered. Asset managers spend ~$30 billion of plan sponsor money every year via equity commissions. While there is no specific requirement that asset managers document commission allocation, common sense dictates that it would be prudent for asset managers to have the ability to track and justify their commission spending. However, common sense is not necessarily common practice.
About Frost Consulting – Frost Consulting is a UK-based firm specializing in equity research and commission management issues, particularly those prefaced by rapid technological, regulatory and economic change. Frost is typically engaged to assist in molding commercial strategies that address evolving market and regulatory structures. www.frostconsulting.co.uk