Broking faces change from ‘unbundling’ effects; Broker research, meetings with corporates, IT and market data services are all bought by fund managers out of underlying client funds by bundling the payment into trading commissions

November 25, 2013 10:29 am

Comment: Broking faces change from ‘unbundling’ effects

By Richard Balarkas

The Financial Conduct Authority’s planned review of the practice of “bundled commission payments” was one of a series of recent announcements that hint at a concerted effort to “bootstrap” a UK financial services sector still mired in the aftermath of the financial crisis. It could yet have a profound effect on bank earnings. When a fund manager buys or sells stock on behalf of a client the commission paid to the broker comes from client assets. This is not in itself a problem as the cost of executing a trade is clear and will, through the settlement process, be attributed to the clients on whose behalf the trade was undertaken.This practice becomes a problem when the commission paid is inflated and used as the vehicle for paying brokers for non-transaction services unrelated to the trade and not necessarily of direct benefit to the funds on whose behalf the trade was undertaken.

Broker research, meetings with corporates, as well as IT and market data services are all bought by fund managers out of underlying client funds by bundling the payment into trading commissions.

End investors might reasonably expect that a fund manager undertakes company research and comes up with investment ideas, and that this core service is covered by the management fee. In practice, many fund managers rely heavily on outsourced research services, mostly from brokers.

Notwithstanding questions about the quality of broker research, the use of client assets to pay for outsourced services leads to over consumption as well as distorting competition among fund managers, execution brokers, research providers and trading venues.

The estimated global spend by fund managers on broker research is in excess of $20bn. This is outsourcing on a grand scale, but unlike other significant outsourcing arrangements the process typically lacks the oversight, governance and controls one might suppose would be in place.

If fund managers bought external research with their own money they might be expected to follow a procurement process in line with the overall complexity of the outsourcing involved, just like any other business. Requirements, formats, frequency, coverage of asset classes would be assessed, leading to a tender process and a decision. Given the money involved one might expect board referral if not explicit approval.

In practice, many fund managers do nothing of the sort. The industry uses an arcane practice called the “broker vote” primarily as a means of determining what share of commissions each broker should receive, not how much they should receive.

Sell-side institutions are already facing a crisis, and unbundling may be the butterfly wing that turns into the perfect storm

While a small minority of fund managers are rigorous in how they review brokers, for the majority the vote remains a somewhat hit-and miss affair wholly unfit for the purpose of governing the use of client money to buy outsourced services.

It is hard to imagine that any new enterprise that came to the City looking for investors would be taken seriously if it had as its revenue and charging model something akin to the broker vote.

Yet the scale of overspend means unbundling may have a dramatic effect on overall investment banking revenues. McKinsey, the management consultancy, recently highlighted that the largest Wall Street banks have a return on equity (RoE) below 8 per cent, set to decline to 4 per cent by 2018.

They need to cut costs by a further 28 per cent to achieve an ROE that covers their cost of capital. Simply enforcing existing FCA rules which ban the use of commissions to pay for corporate access might in theory reduce sellside revenues by a third.

Appropriate prudential controls on the use of commissions to buy research will squeeze margins further. There may also be knock-on effects on the amount of trading. Sell-side institutions are already facing a crisis, and unbundling may be the butterfly wing that turns into the perfect storm.

A clear separation of research and execution services will change the profile of the broking industry. Bundled commissions have helped sustain overcapacity and suboptimal competition for too long. The fallout could be dramatic, but there will be winners as well as losers.

The mindset needs to change from seeing unbundling as a “hassle”, or even as too hard to do, to adopting appropriate standards of corporate governance. How will this change of mindset be evidenced?

Quite simply, when investment managers dispense with the broker vote in favour of a suitably rigorous procurement management process, and when heads of broker research have invoicing systems.

Richard Balarkas is an independent consultant and the former chief executive of Instinet Europe