Unbundling probe to alter research practices

A new regulatory crackdown on conflicts of interest will result in greater unbundling of research and execution fees, with major implications for how research is prepared and sold.

A new regulatory crackdown on conflicts of interest will result in greater unbundling of research and execution fees, with major implications for how research is prepared and sold.

Increased pressure, led by the Financial Services Authority (FSA), will force clear separation of execution and research fees and clamp down on corporate access arrangements after the UK watchdog found only two of 15 asset managers were acting according to current rules.

The FSA published a report on its findings last week and sent letters to CEOs of asset management firms asking them to confirm their company abides by the regulator’s conflict of interest rules after its thematic review of 15 firms, which represented an even cross section of the industry. Responses must be submitted by 28 February, after which follow-up reviews of random firms will occur to ensure asset managers are complying, with the threat of punitive action for those found breaking the rules.

A spokesperson for the Authority said the results of the thematic review were disappointing, although the two firms praised in the report were evidence that companies could successfully comply. 

“These are very well-established rules. They’ve been around for a long time, but we’ve found common practice falls short of these rules. It’s not a case of us needing to change our rules, rather firms need to abide by what’s already there,” the spokesperson said.

CEOs must attest that conflict of interest issues have been discussed in board meetings and that senior management have signed off on the company’s compliance with the FSA’s rules.

Peer-group pressure 

Speaking to theTRADEnews.com Adrian Fitzpatrick, head of trading for asset manager Kames Capital, believes this new push to separate payments is a backdoor route to change sell-side practices.

“The regulators are trying to force an unbundling of the marketplace by putting pressure on the buy-side through peer-group pressure because they don’t have the same clout to force the sell-side to unbundle,” said Fitzpatrick, who believes stricter rules should have been part of previous pushes for unbundling as recommended by the 2001 Myners report.

The FSA report also makes clear the bundling of payments to cover corporate access – where buy-side firms pay to meet with senior management of companies they wish to invest in – will also be stamped out.

“The corporate access element is going to have a huge effect on the buy-side. Any major house needs access to the corporates because the positions we build can be substantial. We need to trust the people running these companies,” said Fitzpatrick, who added that the overall effect of this crackdown could ultimately lead to further shrinkage of the UK finance industry at a time when Asian markets, such as Hong Kong, are stronger than ever.

Fitzpatrick also stated the research delivery of larger sell-side organisations had not kept pace with firms’ structural change in execution, with sales traders now multi tasking across electronic trading, program trading and cash trading.

Buy-side representative body the Investment Management Association (IMA) believes this push will have an overall positive effect on the industry. Guy Sears, the IMA’s wholesale director, said firms will have to control what they spend on research and execution, but also demonstrate that control.

“For some buy-side firms, it will be a wake up call. The brokers will have to look at changes to pricing, but ultimately the FSA has identified industry practices where some asset managers were not sufficiently robust in controlling money spent on behalf of their clients,” said Sears.

Boutique boom? 

The reality facing brokers is diminished income from research, which will likely affect investment banks’ research output as the buy-side moves to tailored, boutique research solutions. 

Rob Boardman, CEO of EMEA operations for agency-broker ITG, believes changing buy-side practices will cause a major reshuffle for sell-side firms.

“The biggest implication for us in the short-term will be increased interest in commission sharing agreements (CSA) because they let firms address issues of conflict of interest without fundamentally overhauling how they pay for research,” said Boardman.

Boardman believes there will be less bank-supplied research sold due to renewed vigor in the unbundling process and thinks the regulator could make unbundling compulsory in the future, which was a significant implication of the Myners report, and the subsequent FSA proposals in 2003’s CP176 document.

“The FSA is clearly saying that managers must be more thoughtful about what they buy and how they buy it. They’ve got to show the research they buy adds value to the fund otherwise they’ll stop buying it,” said Boardman.

Across the Atlantic, conflict of interest for asset managers has been pushed to the bottom of the list for US regulators, swamped by Dodd-Frank Act implementation. Currently, the so-called ‘soft dollars’ issue is protected by legislation.

Matt Samelson, a director at consultancy Woodbine Associates, who will publish a report on the subject later this month said the ‘safe harbour’ embedded in one of the country’s core finance laws would make any change a difficult task for regulators.

“Elimination of soft dollars in the US would require repealing the Securities and Exchange Act of 1934 Section 28(e) safe harbor that permits investment advisors to pay trading commissions over and above the cost of execution for certain bundled services without being in breach of fiduciary duty.

“At the moment, this isn’t a hot-button issue for legislators,” said Samelson.