Unbundling: Opening Pandora’s Box

Industry participants breathed a collective sigh of relief on publication of the Delegated Acts by the European Commission. Yet this relief may be short-lived. The regulators’ attempt to prioritize greater transparency over the cost of and quality of research and execution have opened Pandora’s Box and will radically reshape European capital markets in the process.

While the use of dealing commissions may still be admissible in an unbundled world, the level of scrutiny over how client commissions are now used will demand a dramatic overhaul of current procedures, impacting not only payment of research models but the provision of execution itself.

Few participants anticipated the extent of the proposed changes. A mere 12% of buy-side participants who contributed to the research were planning on implementing the proposed Research Payment Account (RPA), and nearly half were still waiting on the outcome of regulation. The majority of the market have been banking on the continued use of CSAs, albeit with stronger controls.

However, the challenge is the use of dealing commissions within CSAs are just a subsection of what is now required by the European regulators. While CSAs may remain the preferred option for firms to manage dealing commissions currently, this must now be within the constraints of a RPA.

To date there has been limited change to business practices across Europe. Firms have mainly continued to expand their usage of CSAs as a redistribution vehicle for fund commissions within agreements with specific brokers. But RPAs require research budgets and evaluation programs with reporting and assessment obligations; and they may only be funded by a specific charge, determined by a pre-agreed budget.

Investment firms also need to take ownership of the RPA(s) versus the current arrangements where CSAs are pools of dealing commissions often held by the broker. There are options to outsource this to third party offerings, but asset managers still need to be sure of both research procured as well as the execution services received.

As inclusion of CSAs within an RPA framework appears to create an additional layer of complexity, some firms are beginning to ask whether this is the most effective use of increasingly scant resources in addition to incurring a high probability of error. While the benefits of greater transparency in how research commissions are spent and where are self-evident; it will ultimately depend on the individual firm, the type of investments and underlying trading activity that will indicate how firms choose to respond. CSAs in RPAs, stand-alone RPAs or even paying direct from the bottom line will all necessitate increased resource, investment, governance and oversight by an increasingly stretched buy-side.

Nor are the sell-side immune. As unbundling of research takes hold, preconceived ideas and market norms are being discounted and the opportunity for challengers to excel is emerging. While the regulators may be focused on the fidelity of the execution process to enable buy-side firms to make informed choices based on sound rationale, it will also be important for the firms to demonstrate what they do when an execution process is not working. Broker selection can no longer just be an annual review, but a more in-depth and interactive analysis to assess the ability to offer the best, most consistent results for a firm’s clients. As such over half the participants now choose independent providers of execution analysis as their best-in-class.

Subsequently comes a question of what a firm chooses to analyze and why. Transaction Cost Analysis (TCA) will only tell you the cost of the trade; the next step will be to analyze the optimal time to trade relative to the underlying objective, disclosing the total implicit costs of trading. As best execution requirements move across the asset classes, the available liquidity and opportunity cost will become just as important as the price paid.

Where larger buy-side firms are perceived to have the technology to conduct this quantitative analysis, smaller firms may not. Agency brokers and other third-party providers are already clamoring to fill the ensuing void, but whether the provider of analysis can also be the provider of execution services is just one of the many questions yet to be answered as firms’ grapple with the consequences of unbundling.

Even without a direct ban on the use of commissions to pay for research, trustees of pension fund mandates are already questioning whether they should be paying for research. The issue with paying from the bottom line is that the consequences are as yet unknown. Perhaps firms will include the costs within their management charges; perhaps some clients will refuse to pay for research, how will buy-side firms manage their fiduciary responsibilities then? What is certain is that with the asset management industry continuing to consolidate and operate across the globe, changes will resonate far beyond Europe’s borders as firms adopt worldwide models in order to reduce business complexity.

To investigate the full impact of unbundling the research process on order execution, TABB spoke with 48 asset managers trading European equities globally to establish the regulatory challenges they now face and how they propose to address them.