Waters Technology: Broker Commissions: The Great Unbundling

By Timothy Bourgaize Murray | Water's Technology

Broker Commissions:The Great Unbundling Bungle

Handling sell-side research and commissions has typically been a mundane and relatively simple function for investment managers. But regulatory authorities in Europe are about to turn the process upside down with a little-known but potentially impactful vestige of Mifid II. Tim Bourgaize Murray explores the technological ramifications.

The sale of information about listed companies is as old as the stock markets themselves. Tracking and managing the cost of this research is naturally part of the process—and in modern times has often been linked-up or bundled with the cost of executing the trade.

Indeed, even the famous Buttonwood Agreement of 1792, establishing the New York Stock Exchange, really did two very simple things: establish exclusive brokerage agreements, and set the commission rate at .25 percent. Since then, if not before, brokers have always been defined by their proprietary information as much as their access.


The significance of that change is still underestimated I believe, and there are a lot of concerns of where that leads us in terms of long-term health of the research industry going forward. - Tom Conigliaro, Markit


Today, research is still a reliable, commissions-driven and low-margin source of revenue for investment banks and, as technology problems go, fairly unremarkable.

This changed a little bit in recent years as commission-sharing agreements (CSAs) have become the operating norm, with investment managers either building out or outsourcing aggregation platforms to keep everything on track. But these developments have served to only make the process more stable, without much fuss.

Experts in the space, though, tell Waters that a change is afoot in the halls of the European Securities and Markets Authority (ESMA) that could turn all of that on its head—breaking a system that many believe works just fine, projecting a major new cost on investment managers, and potentially “killing sell-side research” altogether, as one source put it. Can technology save it?

Once a Gentle Curve

The evolution of commissions management has followed a gentle and mostly self-sustained curve in the last 10 years. With research once paid for simply with so-called “soft dollars,” the first change came in 2006 when CSAs were introduced, which forced firms to distinguish the cost of execution and cost of research—now about $20 billion—attached to a transaction.

As CSAs’ standardization proliferated, a handful of firms—Convergex’s Westminster Research Associates, Instinet and Markit, among others—have developed CSA aggregation services to help firms link up their research evaluation processes (known in the industry as broker voting and budgeting) and streamline payments. It's a space with lots of room to grow, Instinet Europe CEO Adam Toms tells Waters.

“Over recent years, the move to a CSA structure has been a big step forward. Our data shows that this move has increased significantly over the last 18 months in Europe,” he says. “That was step one, the next was if you have multiple CSAs—typically around 10 for a larger investment manager, but as many as 20 or more—it’s an administrative burden and you need a centralized approach to managing the CSA accruals that you may have with different sell-side firms. Our T-Share CSA aggregation balances are up over 75 percent year-on-year and are reflective of this move. Clients are firmly in the territory where they are using our integrated broker-vote, voting and ranking the research products they consume and aligning to the research budget they have set in hard-dollar terms. They have moved away from allocating a percentage of turnover to brokers as payment for research. There is a clear delineation between trading commission, which will always be variable based on turnover, versus a static dollar number for research”

Indeed, prevailing perception is that the CSA-based approach has generally worked, according to the head of commissions management at one equity research house and brokerage. “When they put CSAs in place, the main idea was that the industry would self-regulate, and it largely has,” he says. “Yes, you would have a few abuse cases, but a review of 1,300 managers by the Financial Conduct Authority (FCA) in the UK found only 17 were not performing CSAs to their liking. As one prominent lawyer in the space has argued, it was a reason to enforce the rules—not a reason to overhaul the whole process.”

Even before storm clouds began gathering, many providers were already taking next steps in trying to envision what a more holistic commissions management workflow should look like. Markit, for example, has invested heavily in a new business unit headed up by Goldman Sachs and Merrill Lynch veteran Tom Conigliaro around the issue.

“We’re looking for more collaboration between the buy side and sell side, developing tools that enable them to better interact and communicate around research, valuation, and execution services quality,” Conigliaro explains. “About 18 months ago, we sensed a greater demand was building, but in pulling together a number of related acquisitions—Wall Street on Demand (now Markit on Demand) and QSG, to name two—we needed a more thoughtful strategic approach. Now we’re in a tidal wave of unbundling and these tools that were once ‘best practice,’ and nice-to-have for most sophisticated managers, are now more of a ‘must-have’ for the masses to meet the changes that are coming.”

Unintended Consequences

The story of those changes—slated for implementation in early 2017 as part of Mifid II—is chock full of alleged personal agendas and surprising vitriol. It also reflects how the regulatory sausage is frequently made in Europe these days.

Many say the push reaches as far back as 2001, but it certainly ramped up in 2013, with an initial paper from the FCA and its erstwhile crusading chief, Martin Wheatley, that alleged industry collusion around commissions and decried the plight of pensions and other investors who indirectly foot the bill for research, without any transparency into what they’re paying for.

As several sources for this article put it, all wishing to remain anonymous, the proposed ESMA rules—which ban the common buy-side practice of using commissions to pay for research, by essentially killing CSAs—range from a “disaster” to a "nightmare" to “exercising the nuclear option.” Some surmise that ESMA farmed out the writing of the language to the FCA, which has been a common practice for the massive Mifid II project. What was once a single regulator’s cause has become an entire region’s problem.

“There is a bit of a witch hunt and religious debate in the FCA now around the effectiveness of active management and the effect its fees have on pension returns on small guys over a 30-year period,” says one source, a former sell-side sales trader.

“Their attitude is that somehow participants are conspiring against these clients, double dipping by charging a management fee as well as for research. You could see how there could be potential conflicts of interest, but at end of the day, a manager’s end goal is to deliver returns. There’s the incentive that supersedes all: Keep the client with performance. But the FCA doesn’t believe that’s happening, and unfortunately that’s why we are where we are now.”

Seeking Clarity

Less than 18 months away from 2017’s marker, much remains unclear. For instance, will this be a regulation—meaning every European market must comply—or a directive, where it’s left to local authorities to interpret the rules? And, assuming a post-CSA environment, which direction will the buy side prefer: set up individual funds, known as Research Payment Accounts (RPAs), into which clients can allocate their own monies for research directly, or avoid that hassle, and simply take this out of their profit-and-loss (P&L) directly? Either way, investment managers are in for it.

“All of that burden that was shared between the buy side, sell side, and providers in the past but is now being pushed to the buy side,” Conigliaro says. “The significance of that change is still underestimated I believe, and there are a lot of concerns of where that leads us in terms of long-term health of the research industry going forward.”

As another sell-sider put it, “Certain managers tried an RPA concept with clients in the past, and it didn’t work then at all. As imagined by ESMA, all the accountants in the world couldn’t keep an RPA, consulting a client for approval every single time a broker vote changes. And it won’t work now.”

Instinet’s Toms takes a slightly brighter approach, calling this simply “another layer of transparency,” and he suggests the same underlying technology can be used to manage RPAs as CSAs. That is why, if it’s going to work, optionality will be crucial.

“The various approaches to evaluation of research and to different payment mechanisms today is the widest dispersion we’ve ever seen," says Toms. "Opinions are very different, as some people are adopting a wait-and-see approach with Mifid II, while others have carried out extensive internal planning and reviews and have started to change their processes.  We’ve had at least 250 meetings on this topic already. But a number of clients believe the end game, be it January 2017 with Mifid II or sometime later, is likely to be an RPA structure anyway.  In these cases clients are moving straight to RPA. We still believe enhancing current CSA structures is an obvious approach to take, but we will need to see if the regulators agree in October.”


The good news is that this represents a significant technology opportunity on two fronts: first, running the RPAs for those who take the plunge, and second, further refining and integrating the vote and budgeting process into the commissions’ workflow.

“It’s complex, but not too different from portfolio accounting,” Conigliaro explains of the first piece. “The whole goal is to spur more conversation between the buy-side fiduciary and underlying clients around how they’re spending research dollars and the effect of that on performance. In terms of mapping the RPAs to different funds for each underlying account and customer, there is great potential for providing reporting solutions. Research evaluation with the broker vote can help determine whether the price paid was appropriate, and they can use that information to negotiate the price in the next period,  up or down. Investment firms have historically had a process to monitor research spend, but it generally was not a systematic or formal process.”

To that point, Instinet’s Toms says smaller shops will likely need more help, depending on what stage of maturity in the “unbundling cycle” they are in. “There will be different approaches depending on size of assets, investment style and level of research consumption” he says.

While some will seek a comprehensive solution for their workflow, others will look at broker voting in particular as part of their calendaring and corporate access activities, using targeted modules from niche providers like A2 Access, which grew out of heritage from former Tiger Cub hedge fund managers and was recently acquired by Dealogic.

“Vote and tracking tools need two things to be successful: customization and participation,” says Billy Fennebresque, A2’s founder. “Each firm needs to make the system their own and for any system to be useful, it has to be used by the actual investment professionals. Tiger specifically represents a lineage of some of the best investment professionals in the world and we were able to leverage that network to design, build, and execute on the product. We started out as a corporate access aggregation tool and developed our A2 tracking product and enhanced our broker vote functionality to capture all touchpoints between the buy side and their sell-side partners. We’ve met with ConvergEx and other commission management tools around possible collaboration, as well.”


Another consideration remains very relevant, sources say, depending on the Mifid II outcome: regulatory arbitrage and ring-fencing.

“It’s ironic, in fact, that the big asset managers that could potentially benefit from these rules have indicated that they understand the unintended consequences that a hard unbundling could have on the availability of research,” says Westminster co-president Chris Tiscornia. “While there is a concern for both buy-side cost and sell-side research that a global manager might look at the proposed rules and take the most conservative approach—implementing standards across all their businesses—some shops could move operations to regions with a more favorable regulatory climate, or ring-fence the rest of their global operations.”

As the equity research house’s head of commission management, who is also involved with the Alliance to Preserve Investment Research (Apir), an industry group, puts it, keeping separate US accounts and balanced accounts could produce a “potential tech play” for providers as well.

But in the end, he sees most firms sucking up the cost themselves. “Ninety percent or more will just pay out of P&L; it’s not that they want to, so much as because they know it will be a nightmare to do the RPAs in the way they’re currently proposed. But like everyone, we’re waiting for ESMA’s final ruling.”


The other key, Tiscornia says, is that much of the innovation in the research space is being produced by independent providers—using satellite imagery, web-scraping, credit card purchase data, social media and other big data—which has allowed the buy side closer proximity to the raw information, breaking down the long-established buy–sell relationship. “This mirrors what’s going on in society itself, where clients are trying to get as close to the data as they can to make informed decisions, complementing their use of traditional research to arrive at their opinion whether to buy, sell or hold a position,” Tiscornia says.

Toms describes this as a revolution in “reverse inquiry” for research, where the buy side is now “pulling” research to them, rather than having it pushed upon them, and he says many in the research and commission space are eyeing app-store models to bring these together, just as they're preparing for the new rules.

Will Mifid II prove lethal? Maybe not, but a classic function that once felt calm and casual now seems anything but.

Salient Points

  • Typically funded by commissions from the buy side, sell-side research is bracing for a potentially huge disruption as ESMA continues its work on Mifid II. In particular, the proposed rules in play would require new methods of funding—either through client-specific accounts known as RPAs, or through firms’ own P&L—as well as better dexterity around broker vote and budgeting processes.
  • Technology providers in the space are using current CSA aggregation platforms as well as borrowing from portfolio accounting systems to develop a workflow suitable for firms looking to employ RPAs, though there is an expectation that many managers may look at regulatory arbitrage or ring-fencing possibilities instead.
  • The situation has only served to further dis-intermediate the traditional buy side–sell side relationship for research as more buy-side firms seek raw data and information to plug into their internal research functions.