New York – The Financial Services Authority (FSA), the UK markets regulator, recently released a report assessing the impact of the commission disclosure regime it implemented in 2006. The results are a mixed bag. On the positive side, use of Commission Sharing Arrangements (CSAs) went up, expenditures through CSAs increased and investors used a greater variety of third party research providers. However, it does not appear that the new regime has had much impact on the market structure of research. Brokers still receive the bulk of their payments for research through bundled commissions so there has been no big shift to transparent pricing for research services. If the FSA wants more commission transparency it will have to regulate it, or ban the practice of paying for research through commissions.
Last month, the FSA released a report reviewing the success of the commission disclosure requirements it implemented beginning January, 2006. The report was prepared by a consulting firm hired by the FSA to track various metrics measuring the impact of regulation which required investors to provide disclosure on the amounts spent on research and on execution. The FSA’s intent was to unbundle research payments from execution. Prior to the disclosure requirements, research payments were largely bundled into execution payments. The FSA hoped that by mandating disclosure, scrutiny from pension funds and other investor clients would require more transparency in the payment of commissions for research.
In preparing the report, the consulting firm, Oxera, surveyed investors, brokers and pension funds prior to the implementation of the new regulations, and two years after. By tracking the changes pre- and post-implementation, the report provides a snapshot of the effectiveness of the regulation during the first couple of years of usage. The study was conducted in August and September 2008 and covers the three years from 2005 through 2007.
Use of CSAs
The headline result of the report is that CSA usage increased as a result of the FSA’s regulation. The proportion of fund managers with CSAs increased from 50% to 70% from 2005 to 2007. More providers were paid from CSAs, from an average of just under 20 to over 40 providers. Providers include both brokerage firms and independent research. In the survey, brokers were around 60% of the research providers paid through CSAs and independent research providers were around 40%.
Strangely, although the number of providers paid through CSAs increased, the number of bundled brokerage providers has not decreased. The average number of bundled brokerage providers was around 60 in 2005, dips to around 54 in 2006, then bounces back to 60 in 2007. You would think that the number of bundled brokerage providers would decrease as more brokers are paid through CSAs…
The FSA was justifiably cheered by increased CSA usage because CSAs can potentially displace bundled brokerage research, as the report puts it, “a mechanism by which the transparency of research pricing, and competition, can potentially be enhanced.” The question is whether the CSA mechanism is actually having this effect. The data on expenditures through CSAs raises doubts. The report highlights that the majority of investors’ research expenditures are going through CSAs, according to the investors. In 2007, investors surveyed by Oxera reported that 36% of their research payments were through bundled arrangements whereas 64% of research payments went through CSAs (of which 24% went to the brokerage firm at which the CSA commissions were generated.) This happy news is trumpeted in the executive summary and press releases summarizing the report.
Not highlighted in the executive summary is the brokers’ version of reality, namely that 63% of the research payments they receive are through bundled commissions, with only 36% through CSAs and 1% through cash. This result is the exact opposite of what investors report. Even more perplexing, Oxera says the brokers surveyed represent large, full-service brokerage firms, which receive about 75% of the research payments according to other areas of the report.
Perhaps the answer to this conundrum goes back to the way the fees are negotiated between brokers and investors. The brokerage fees for research are still negotiated in aggregate. Investors tell brokers what level of commissions they intend to allocate for research and brokers respond by saying that a higher amount is required to maintain the current level of service received. Brokers can be forgiven if they still view this as bundled brokerage.
The Oxera report makes much of declining commission rates, driven by increased use of electronic trading. Rates for the various forms of electronic trading are declining as well. However, the report does not ballyhoo the fact that bundled commission rates are largely unchanged. According to brokerage firms, bundled rates declined to 14.8 bp in 2005 from 16.8 bp in 2003, then increased back to 16.3 bp in 2007. As a result of the FSA’s new regulations, bundled commissions have to be decomposed into an execution constituent and a research constituent. The execution component of the bundled commissions (7.2 bp in 2007) is significantly higher than any of the electronic trading commissions (DMA is 3.7 bp, algorithmic is 5.6 bp and program trades are 4.1 bp.)
Even more interesting is how the constituents of bundled brokerage fees change. The constituent for execution declines from 7.7 bp in 2006 to 7.2 bp in 2007. This decline is more than offset by an increase in the research constituent from 8 bp in 2006 to 9 bp in 2007! No wonder that execution only brokers are trying desperately to get into the research game…
The FSA expected the market for research to become less concentrated, with investment managers gaining easier access to a wider range of research providers through CSAs. Based on the Oxera report, this does not appear to be the case. The proportion of trades going to the top 15 brokers was 79% in 2007, compared to 82% in 2003. There is a decrease, but it is very slight, and it certainly does not signal a significant change in market structure.
Most dispiriting of all, the intended recipients of the disclosure–pension funds–are paying cursory attention to the information, if at all. According to the report, most investment managers received no feedback at all from pension funds. Pension funds reported similar results. Five out of six pension funds reported that they did not use the information received at all.
The more things change the more they stay the same
Ok, let’s review the results. CSA usage is up while the number of bundled brokerage providers stays the same. Investors report that 64% of their research payments are through CSAs while large brokers (who get the majority of payments) report that 63% of their research payments are through bundled arrangements. Electronic commissions are declining while bundled commissions are not. The research portion of bundled commissions actually increases. Market structure is largely unchanged with 79% of trades going to the top 15 brokers. Pension funds largely ignore the information and do not provide feedback to their investment managers.
This is not the picture of a dramatically changed research marketplace. In fairness to the FSA, the report focuses on the initial results of the first two years after implementation. Some regulators, such as the AMF in France, subsequently followed the FSA in adopting similar disclosure regimes, but this was not until mid-2007. Some regulators, such as the SEC in the US, promised disclosure regulation, but did not follow up. So for the period of the report, the FSA was all by its lonesome. Brokerages based in other domiciles might adopt CSAs (or the US version called Client Commission Arrangements or CCAs), but not the additional disclosure requirements required by FSA regulation.
It will be interesting to see how the credit crisis, and the ensuing declines in commissions available for payment of research, impacts the research marketplace. Will this stimulate more transparency and competition between research providers? While we think that non-brokerage research will do relatively better than brokerage research, we don’t expect the crisis to create the dramatic changes in market structure that the FSA was anticipating when it put its disclosure regime in place.
The FSA has chosen to put a happy face on the Oxera report, focusing on the rise of CSAs. This suggests that the FSA has no immediate intentions of new regulatory action to further facilitate (or require) research unbundling. The FSA has many other fires to fight. Our view is that the failure of efforts to create a more gradual, market-led transformation of commission transparency increases the chance of future regulation banning the practice of paying for research through commissions altogether. When that happens, and how, is anyone’s guess, but it is not hard to imagine an ambitious attorney general grabbing the topic and milking it for all its worth.