New York, NY – The Financial Services Authority’s regulations regarding commission disclosure a few years ago, and the SEC’s soft dollar guidance released last summer, have both boosted the market’s awareness, and ramped up demand for third-party commission-management software systems. And while we think that these software systems, and the broker vote they support, are an extremely important part of the research and broker payment process, it is clear these systems do not help buy-side firms focus their client commission spend on the best execution and research providers possible.
The Cause of Increased Demand
Many industry experts acknowledge that the new, stricter soft-dollar regulations in the United States and United Kingdom have started to have broad implications for fund managers, brokers, and financial technology vendors.
Ultimately, the new regulatory regime has increased money managers’ burden of proof that their use of client commissions complies with new rules. Unfortunately, many small and mid-sized managers are not really prepared to deal with the increased requirement to develop a process to manage their commission use. As a result, many managers have turned to third-party commission management software systems to help them track and justify how they spend client commissions.
The Size and Growth of the Market
In 2005, Financial Insights estimated that the market for commission management software currently was $81 million globally. However, they went on to predict that this specialized market had the potential to be worth $75 million in the United States alone and as much as $125 million globally by the end of 2007.
Financial Insights suggested that the primary market for commission management solutions would be buy-side institutions with fewer than $100 billion in assets under management. Larger firms were expected to develop these systems in-house. A few of the most prominent firms in this burgeoning space include Cogent Consulting LLC, Eze Castle Software, Rontech, Ltd., and Financial Sockets LLC.
Commission Management and the Broker Vote
Commission management systems have traditionally worked hand in hand with buy-side investors’ “broker vote” process to help money management firms determine how much to pay their brokers and research providers for execution and research services they proffer.
As a result, these systems have helped portfolio managers, analysts, and traders track and rate the value of the various services they received, and allocate their commissions to pay for these services. Consequently, the commission management systems and the broker vote have been extremely important in helping money managers determine how to reward the research providers and execution partners that are currently in their broker vote.
The Flaw In The Process
However, commission management systems and the broker vote have done very little to help a portfolio manager, buy-side director of research, or director of trading determine if they have the right providers in the broker vote to begin with. In other words, the existing process has not really answered questions like,
“Should we be using every execution partner in the pool?”
“Are there other trading counterparties that we should consider?” or
“Who are the best sell-side and independent research providers in all of the areas that matter to my firm?”
In fact, in the past few months we have spoken to hundreds of Buy-Side Directors of Research and have discovered that over 85% of these firms have a “hands off” process, leaving the decisions of which research to use up to individual portfolio managers and analysts.
And while this is not bad in of itself (after all the PM and analyst are experts in their industry or sector), it is clear that this process is in no ways rigorous and it is absolutely not systematic. In fact, the explosion in the research industry over the past few years means that either PMs and analysts must waste a great deal of their time trying to vette all of the research providers in their space – or they will continue to use who they have always used, thereby missing out on many of the new most innovative firms.
Some Buy-Side firms that have implemented this type of “laissez fare” process have established another level of vetting and approval to ensure that the research firms recommended are in fact legitimate and appropriate. Unfortunately, most of these firms don’t really ask themselves if the research firms recommended are in fact the best providers for the job. And even if they did, most firms don’t have the tools, expertise, or time to address this issue.
Why Does This Matter?
Of course, some of you might ask why does this matter? In the past, clients did not care how their commissions were being spent. This was true, in large part, because institutional customers did not have sufficient disclosure and transparency about how their managers were using their commission dollars.
However, things are now changing. Given various regulatory and market developments, clients are becoming increasingly more interested in making sure that their assets (commissions) are being spent properly. They will also want to make sure that their managers have developed and have implemented a rigorous “prudent man” process to make sure that their commissions are being spent wisely (on the best execution partners and best research providers).
The FSA’s move to mandate commission transparency, the Canadian Securities Association’s similar proposal, and the US Department of Labor’s proposal to implement stringent fiduciary requirements on the part of plan sponsors to manage these assets more proactively are all changing the rules of the game.
A Possible Solution
So how can buy-side firms address this short coming? One possible solution is to develop an assessment process that would “overlay” the broker vote and commission management platform for the expressed purpose of helping buy-side investors make sure they have included the right execution partners and research providers in their broker vote in the first place.
Of course, this is easier said than done as every institutional investors has execution requirements and research needs that are unique to that client. However, such an overlay is possible, and more importantly, this type of process will ultimately help fulfill the changing fiduciary needs of the client.