Last July, Bank of New York purchased commission recapture broker
Lynch, Jones & Ryan from Instinet Group for $159 million. The deal is seen as a feather in BONY's cap at a time when many believe the commission recapture industry is poised for decline.
"This is not a dying business," says Todd Burns, president of LJR. "It's gradually growing for us. But it is consolidating." He says it's consolidating because clients are looking for brokers to provide services across a variety of asset classes-domestic equities, domestic fixed-income and international-along with comprehensive reporting systems and client services.
"It's an industry where the smaller providers are gradually disappearing and there will eventually be just a few firms," the exec adds.
That scenario is plausible, observers say, in an environment where there is greater unbundling of research and execution costs and average commission rates continue to shrink. Consolidation could increase the business prospects for some firms even as the pool of available commissions gets smaller.
Tom Conigliari, a Goldman Sachs executive in charge of third-party research and institutional brokerage, said recently that commission recapture will eventually be priced out of the market by falling commissions. He said Goldman is already seeing a reduction in demand for commission recapture.
Declining rates decrease the incentive for Wall Street brokers to offer recapture services. Full-service brokers earn less on those transactions since they're giving most of the commission to the recapture broker.
According to buyside traders, at least one large broker insists on retaining a minimum amount on low-commission recaptured trades. Others are rumored to be scaling back their recapture business or pulling out of broker networks.
All kinds of trades can be recaptured, says Quinn Zimmerman, global head of commission recapture at Russell Investment Group, but high-touch trades are "best served as commission recapture targeted trades." He adds: "If a manager is utilizing low-touch trades that make less sense from a commission recapture standpoint, then the client has achieved what commission recapture set out to do-which is to lower the total expense of trading."
Richard Kos, president of Kos Consultants in Connecticut, notes: "With technology and direct market access solutions playing a bigger role in trading, commissions will decline even more, so managers will be able to trade at execution-only rates that are probably as low as what sponsors are getting with commission recapture. Why would a plan pay 4.5 cents per share to get back 3 cents per share, when it could pay 1.5 cent a share and be done? The answer is, it wouldn't."
How it Works
The practice of commission recapture, which began gaining ground in the 1970s, involves brokers giving back a portion of the commissions they get from money managers to the plan sponsor or underlying fund. Commission recapture is used by plan sponsors and institutional accounts to recoup some of the cost of commissions by directing their investment managers to use a commission recapture broker.
A pension fund setting up a recapture program will ask an investment manager to direct a percentage of the plan's trades to a particular broker or broker network. If the manager trades with a broker in the recapture firm's network, the "recapture broker" functions as the introducing broker to the firm executing the order. The executing broker keeps a small percentage of the commission and sends the rest to the recapture broker, which then sends most of that to the plan sponsor.
Usually about 60 percent to 75 percent of U.S. equity commissions on recaptured trades are returned to the client, with a smaller percentage recaptured for international trades.
"Commission recapture exists for one reason and one reason only," says Bill Conlin, executive vice president at institutional broker Abel/Noser Corp. "Investment managers historically thought commission dollars were theirs, back when commissions were 6 cents or 7 cents per share. This is a way for clients to save money."
"Commission recapture has been a kinder, gentler way of reducing commission costs without anyone coming right out and saying 6 cents per share is outrageous," says Edward Siedle, founder of Benchmark Financial Services, an advisory and consulting firm in Florida. "Commission recapture still exists because it serves the interests of a lot of market participants-of continuing to conceal the true cost of trading."
Data from research house Greenwich Associates depict a flat business. In 2005, commission recapture accounted for $790 million, or 7 percent of U.S. equities commissions paid to brokers. That's level with the previous year and up slightly from 6 percent in 2003. Greenwich reviewed the trading practices of 400 U.S. institutions in deriving its numbers.
Commission recapture grew up alongside soft dollars and is considered by many to be tied to its fate. As the soft dollar business shrinks and as the cost of execution becomes more transparent, commission recapture is expected to wane.
"The soft-dollar industry is a size 14 dress and it should be a size 8," says consultant Kos. "Commission recapture is essentially a way to unbundle a bundled industry." Soft dollars accounted for $1.13 billion, or 10 percent of overall commissions in 2005, according to Greenwich, down from 12 percent in 2003.
BNY/Lynch Jones & Ryan is considered the largest commission recapture broker, with more than 3,000 clients, including corporate pension plans, public pension plans, Taft-Hartley plans, endowments, foundations and mutual funds. Abel/Noser Corp., Capital Institutional Services and Russell Investment Group are among the dominant recapture brokers. Northern Trust, State Street Corp. and ITG Inc.'s Hoenig broker-dealer are also large broker-dealers with a significant commitment to the business. Many smaller brokerages also provide commission recapture.
The LJR purchase made sense for BNY Brokerage for two broad reasons. Commission recapture clients typically plan sponsors, which include corporate, government, union and other pension plans-are "strategically important clients to us," says Carey Pack, BNY Brokerages president. "The bank is committed to offering them custody, securities lending, brokerage and transition management services." BONY's agency trading business also gives LJR a fuller range of trading options to meet recapture commitments, including program, algorithmic and block trades.
Commission recapture is now a fairly mature business, but it has faced criticism over the years. The repeated charge was that many recapture brokers simply weren't good and gave clients inferior executions. A client might save money in outright commissions, but the overall effect was to increase costs through bad decisions and inefficient trading.
Expertise
Even now this criticism rings true in some quarters. "A broker that does primarily commission recapture may not have the same ability to execute as a broker whose business is handling more discretionary or block trades," says Michael Keady, who runs Fiduciary Investing Practices, a New Jersey-based consulting firm to mutual fund boards. "It simply won't have the personnel, tools, access to automated markets and expertise to match up natural counterparties."
To meet the demands of money managers, commission recapture firms have expanded their correspondent networks to encompass a range of executing brokers. These lists now include large Wall Street firms like Merrill Lynch, Lehman Brothers and UBS-firms investment managers are likely to use in their normal course of trading. That means managers don't have to alter the way they execute trades to satisfy a client's demand for commission recapture.
"The days are gone when commission recapture involved small shops with limited trading and the manager held his breath when he parceled out trades because he didn't have enough options," says BONY's Pack. LJR executes 60 percent of its U.S. business through BONY's desk, although it has more than 30 brokers in its network globally, including Citigroup, Merrill, Lehman, UBS and Goldman Sachs.
Most of the larger and established commission recapture brokers have active trading desks. Abel/Noser, for example, executes 90 percent of its recapture business through its own desk. The broker has gone from no broker network for U.S. equities a few years ago to five correspondent brokers, including Merrill Lynch, Citicorp and Lehman.
Abel/Noser also provides most of its 400 recapture clients with its transaction cost analysis product so they can measure overall trading costs.
Changes Afoot
Despite the improvements, changes are afoot that could eventually make commission recapture unnecessary. The Financial Services Authority in the United Kingdom is encouraging greater unbundling of research and execution services. The Securities and Exchange Commission is following the FSA's lead in many regards. Those regulatory advances, coupled with recent developments such as Fidelity Investment's decision to purchase research from Lehman and Deutsche Bank with hard dollars, increase the likelihood that commission rates will decline.
And lower rates reduce the need for commission recapture. "It would be nice if institutional commission rates went down to the marginal cost so commission recapture programs wouldn't be necessary," Robert Plaze, associate director of the SEC's Division of Investment Management, told Traders Magazine. But recapture still remains a way for some market participants to negotiate lower rates-and "it's lawful for them to do that," he adds.
David Rothenberg, Russell's director of implementation services, a group that includes the commission recapture business, adds that commission-sharing arrangements and other current efforts by brokers to provide more transparency into commission costs occupy an "evolutionary path" from fully bundled to fully unbundled trades. "If we get to the end of that progression, which is fully unbundling, then commission recapture will have served its purpose," he notes.
Withering
Recapture brokers say they are prepared for the practice to wither. "Commission recapture is like getting an execution-only rate," says Abel/Noser's Conlin. "But why have the money come out of a plan just to put it back in?" Conlin notes that Abel/Noser has a lot of clients that simply pay low institutional brokerage rates, but that some still want a rebate to show their board they're saving money or because they need it to pay for fund expenses.
"We've always said either/or," Conlin says. "We can do low rates, which makes tremendous sense, or we can do recapture."
BNY Brokerage makes the same case. If there's more unbundling and commission rates decline, the prospects for commission recapture will grow dimmer. But BONY's business would simply switch over. "If everything completely and absolutely unbundled globally, we'd just be institutional discount brokers," says Burns. "We wouldn't be called commission recapture brokers."
Diagramming Recapture
Here's how a commission recapture program works. A plan sponsor, usually working with a consultant, decides to use a commission recapture program to reduce its overall commissions. It sends a "direction letter" to its investment managers asking them to direct a target percentage of the plan's trades, typically subject to best execution, to a particular broker or broker network.
Ideally, the investment manager trades as he normally would, allocating pieces of the executed order to various client accounts at the end of the day. If the manager trades with a broker in the recapture firm's network, the recapture broker is the introducing broker to the firm executing the order. The executing broker keeps a small percentage of the commission and sends the rest to the recapture firm, which then sends most of that to the plan sponsor. A manager can also ask another broker to stepout a portion of a trade to a commission recapture broker.
The plan sponsor gets the recaptured commission in cash or can have the recapture firm pay the sponsor's administrative expenses. These expenses can include accounting fees, custodian fees, transfer agency costs and any other fund expenses allowed by the plan's board of directors.
SEC Scrutiny
The Securities and Exchange Commission's Office of Compliance Inspections and Examinations (OCIE) recently began focusing on an aspect of the commission recapture business rife with potential conflicts: pension fund consultants' relationships with broker-dealers. Last May the SEC voiced concern about the independence of their advice, based on a study of 24 consultants. More than 1,800 investment advisers currently provide consulting to pension funds.
In a December speech, Lori Richards, OCIE's director, spelled out the problem. She said consultants paid through recaptured dollars could be motivated to recommend a particular commission recapture broker or an active trading strategy that is not in the best interests of the fund. And if the consultant gets a percentage of the commissions recaptured, the pension plan could overpay for the consultant's services. "These relationships with broker-dealers could also provide a mechanism for money managers to compensate pension consultants, perhaps as a way to curry favor with the pension consultant," she said.
OCIE recommends that plan sponsors take a hard line with consultants to flush out conflicts of interest that could compromise their advice.
