The Changing Use Of Client Commissions
Joe Kassel, Global Head of Dealing & Exposure Management at AMP Capital, outlines the effects of the FCA’s proposed rules for the usage of client commissions on the buy-side.
Recent joint statements from the UK’s FCA and Europe’s ESMA have re-focused attention on Commission Sharing Arrangements, asking the buy-side to revisit their relationships with research and execution providers across jurisdictions. In recent years the uptake in usage of CSAs has allowed asset managers flexibility in implementation, to meet their best execution obligations but has still not fully satisfied regulators that client commissions are being managed to maximum effect, nor fully resolved concerns about conflicts of interest. The FCA in their most recent discussion paper on this topic appears to be distancing itself from its principles-based approach in favour of a far stronger view. The FCA are arguing that the only way to eliminate any conflict between managers and their clients, as it relates to usage of client commissions, is to more or less eliminate using commissions for any research purposes with a limited exception for minor non-monetary benefits.
Our view is if buy-side firms act ethically by managing and making transparent any perceived conflicts arising from turnover and ensure any use of client commissions for research meets a specific standard, and that brokerage fees are commercial and market based then this is in the client’s interest to do so. Where there are concerns pertaining to market conduct, they should be closely regulated in a transparent way to ensure information is available to all investors at the same time.
How to pay
Considering the usage of client commissions, the test should be whether the use of those commissions accrues directly to the client whose commissions are paying for that trade. The commissions that buy-sides pay to brokers for execution and research are known, but more importantly, they are an explicit component of the investment performance of funds in our portfolios. The buy-side must give account directly to the customer whose commissions they use for that purpose.
The FCA’s proposal is that investment managers must pay for research using their own resources, and then seek to recoup through increased investment management fees. What has not been fully acknowledged is that in practice this is already occurring. For example, if a firm is 90-100% reliant upon their own internally generated research, then the commission rate they pay for executing trades should be an execution only rate. If another firm uses varying degrees of third party research, which they pay for using client commissions, then that should be reflected in an incremental commission rate. Those numbers are all known and are provided to those firms’ clients. The money management model is part of a firm’s client strategy.
It is worth noting we differentiate between soft dollars and commission sharing arrangements. AMP Capital does not participate in soft dollar arrangements because it carries very specific connotations which we are strongly against e.g. paying for hardware or raw data. For value adding research we do currently use commission sharing agreements, and as a percentage of total firm commissions they account for approximately 15-20%. We consider this key to being able to meet our best execution obligations by only dealing with brokers which meet required execution capability criteria.
To pay for third-party research, the research must meet certain criteria, such as being capable of triggering an investment decision, representing original thought, having intellectual rigour and involving analysis to reach meaningful conclusions.
The application of those principles varies, but the principle is now well understood, certainly in Australia, that to qualify for payment, research has to be original and value adding and most specifically, for the direct benefit of the particular client whose commissions are being used to pay for that research.
The big point that should not get lost is the need for strong regulatory oversight to prevent the misuse of client commissions because in the past there have been clear examples of misuse. The very simple test should be that the use of a client’s commissions is in that client’s best interest.
The ideal solution is for globally agreed standards and requirements regarding CSAs because of the operational efficiencies of not having to create rules for every jurisdiction’s requirements. For example, IOSCO or various regulators could frame workable measures while honouring the original market-based, competition-friendly objectives they value.
The FCA and ESMA’s comments received so much global attention because they spoke collectively on the topic. After a period of silence on this topic, it is appropriate for the industry to have consistent guidance from all regulators. The quality of the measures they choose will determine the uptake of similar rules in other regions.
The technology gap
Historically, CSA’s were openly promoted by the regulator, particularly by the then-FSA, to encourage independent research and foster diversity in place of the investment banks’ oligopoly on the provision of research. However, it has not had success creating a single delivery mechanism to enable the proliferation of independent research.
At one extreme, where the usage of client commissions to pay for research is completely prohibited, that will impact trading commissions because the conversation is about the bundled commission rate. That application of technology has brought the real cost of trading down. For example, commission rates in Australia in the last ten years have arguably dropped the better part of 15-20 basis points in terms of a blended rate to the current single-digit level.
The point should not be lost that to the end investor, a significant outcome has actually been achieved in the form of lower costs and streamlined research requirements from investment managers, as well as the service research providers can afford to provide in a low commission rate environment.
Amongst the bulge bracket firms, the provision of research is more differentiated than in execution services. The idea of any one firm being better at execution can change quite quickly. No one firm has a natural advantage on execution services on a stand-alone basis, and if the industry moved to a place where execution was the only input as with whom buy-sides deal then it could be less stable than it is now.
As an industry we have come a long way. Our most recent internal review, conducted this year, focused on our role as a global asset manager rather than just Australia, and our approach was to find the highest common denominator. In that context, we leaned closely on the FCA’s previous CSA guidance from 2006, when they started clarifying what client commissions can be used for in terms of execution and research. Their principles-based approach anticipated that the industry itself would agree and standardise, and we still believe this can happen.