The Securities and Exchange Commission last month gave money managers the green light to pay for research services with their clients' commission dollars. But that didn't stop the country's largest buysider from declaring open war on the practice. Fidelity Investments struck a deal with Lehman Brothers recently to pay for Lehman's research with its own hard-earned cash rather than that of its millions of small investors. It is pursuing similar deals with other brokers.
As part of its campaign, Fidelity has also publicly egged on its many competitors to do the same and use commissions strictly for executions. Fidelity's move to decouple its payments for research from those for executions was not a complete surprise to those in the trading industry. The buyside gorilla had declared its willingness to unbundle in a letter to the SEC just last year.
But actually doing so has created a stir on the Street. Executives are now trying to figure out if more firms are likely to follow in Fidelity's footsteps. And, if so, what will be the likely impact on the bottom lines of both the sellside and the buyside?
It's all very speculative at this point. "It's too early to tell," Larry Leibowitz, chief operating officer of UBS' equities operation told Traders Magazine. "There has been a dance [between the buyside and the sellside] for the last year or so. The real question is: Do we go to full unbundling like Fidelity is claiming it is doing or do we just end up with more disclosure?''
Tougher Disclosure
More disclosure is extremely likely, industry sources say. Money managers are asking their brokers for help in breaking out their commissions between research and executions. And they are getting it.
"We work with our clients to help them solve their problems," Leibowitz said. "Part of that is helping them with disclosure."
Not everyone is as circumspect as Leibowitz about the future of unbundling. Some are convinced the great unraveling has begun.
"I think there is a very good chance that the rest of the industry will follow Fidelity's lead," said Ken Worthington, a securities industry analyst with CIBC World Markets. And if that happens, he adds, revenues for "the cash equities industry will inevitably decline." He didn't provide a figure, but said Fidelity's action was already having an effect.
"We believe these actions," Worthington wrote in a recent report, "will encourage mutual fund boards and regulators to force other asset managers to unbundle." Others agree.
"Fund boards will definitely go for unbundling because it will lead to greater transparency, which everyone wants," according to Mike Keady, an industry consultant. Keady, a former Plexus Group partner, is an advisory board member of the Mutual Fund Directors Forum in Washington, D.C. The group is a non-profit organization representing independent directors. Keady also runs his own firm, Fiduciary Investing Practices. Keady expects the Mutual Fund Directors Forum to examine unbundling.
Although other fund companies hadn't publicly announced their intent to follow Fidelity's lead at press time, a Knight Capital Group executive predicted unbundling will become a trend. Greg Voetsch, executive vice president in charge of Knight's institutional business, said other fund companies will follow Fidelity. "There are definitely other accounts where this is happening, but it's not being done publicly yet."
(Deutsche Bank Securities, industry sources say, has agreed to unbundle with Fidelity. Deutsche declined to comment.)
Voetsch said unbundling would be a positive for Knight in light of its execution-only model. Its lack of fundamental research prevents it from winning some potential clients. "However, unbundling is beginning to change this and is in fact accelerating," Voetsch said.
A buyside official, who requested anonymity said: "I wouldn't be surprised if many people look at this and decide this is a better way to conduct buyside business." The official, an executive with a large buyside firm, said those money managers who support Fidelity's move believe it can lower costs. He added that they also believe unbundling can insulate firms from potential regulatory problems should regulators stipulate rigorous new disclosure rules.
Fidelity believes the rest of the industry should follow.
"While we believe that the arrangement we've entered into with Lehman Brothers will benefit our mutual funds," a Fidelity spokesman said in a statement to Traders Magazine, "we also strongly believe that the industry as a whole should re-examine the use of soft dollars for research. And we would view an industry response that moves toward payment for execution-only commissions as significant."
The giant money manager also cautioned that it is "difficult for one fund group such as Fidelity to effect industry-wide change."
Price Tag
Cheryl Cargie, head trader at Ariel Capital Management, believes Fidelity will redefine trading industry practices, "much to the chagrin of the smaller firms." She warned that unbundling will mean the sellside will be able to set prices and "many smaller firms won't be able to write a check for research."
Cargie said that Ariel is now putting a price tag on the research and brokerage services it receives.
Cargie's point that smaller money managers will have a tough time paying for research out of pocket is the main reason why some in the industry see no future for unbundling. Fidelity is rich enough to afford research and powerful enough to win company access, but most shops aren't.
Many see the Fidelity/Lehman arrangement as a one-time event. Lee Pickard, a Washington-based securities attorney who once served in the SEC, said he doesn't believe that other firms will follow Fidelity's lead. Pickard said the industry had been fearful that the SEC would impose unbundling, but it has yet to do so. He adds that money managers can still use alternative client commission practices without fear of problems because regulators are not discouraging them, merely clarifying them.
"They have certified much of what we are already doing," he said.
Fido's move came as regulators on both sides of the Atlantic were revisiting commission rules. The SEC recently issued an interpretive release recommending the restricted use of alternative commission arrangements, which were given a safe harbor back in the mid-1970s after commission rates were de-regulated. This safe harbor was contained in the famous Section 28(e) of the securities code. (See sidebar.)
The SEC's action comes soon after the United Kingdom's Financial Services Authority (FSA) tightened up the use of alternative commission arrangements. It also required tougher disclosure standards.
Disclosure standards are very specific. Asset managers in Britain must disclose to every client what was paid to each broker and what was paid for research and execution. What the British regulator has done is important. That's because the SEC said that, in the global marketplace, it seeks to have rules that are "compatible" with the FSA approach. Still, the British securities law has no equivalent of 28(e).
The Coming Rules
The SEC release didn't go into new disclosure requirements. Today the regulator requires that commission arrangements be disclosed on the so-called ADV form, but do not require a cost breakout.
The SEC has just begun to revisit this issue. In the release, the SEC said, "The Commission is also considering whether at a later time to propose requirements for disclosure and record keeping of client commission arrangements." It is not clear when the SEC will take up the issue, but some Commission watchers believe it will be in the next six months. "I believe," said one brokerage executive who watches the Commission, "that the SEC will require some kind of disclosure standards in the first half of 2006. But whether they will propose some sort of FSA model or not, that's just not clear now."
Industry Impact
If Fidelity's unbundling action represents a trend, then it will likely have a significant impact on the finances of both the buyside and the sellside. It will also effect how they conduct business, several industry players told Traders Magazine. They listed several likely consequences for the buyside and the sellside.
For the sellside, the end or curtailment of soft dollars would mean that billions of commission dollars would disappear, according to analysts. And the kind of firms that will survive or prosper in the age of unbundling will change, a brokerage official predicted. One type of business that will likely face problems is the research-driven firm, he said.
"The small- to mid-size firms that are going to compete effectively in a best-execution environment are going to need certain things," said Ray Killian, chairman, chief executive officer and president of ITG, an execution-only broker. "They better have the best electronic connectivity, they better have the algorithms and they better have good pre- and post-trade measurements in place because they're going to have report cards on how they're doing," he said.
Potentially, unbundling could result in a 25 percent drop in revenue for Wall Street's beleaguered cash equities divisions, according to a report by Morgan Stanley, "Fido Sneezes. Who Catches a Cold?"
"This would shave an estimated $1.6 billion off the current estimated $6.2 billion U.S. commission pool generated by traditional buyside clients," according to the report. The figure exempts commissions from hedge funds, which most observers said would not be affected by unbundling.
Killian added that unbundling will also hurt the sellside's cost structure. "The industry won't be able to afford a big research staff. People are going to be a lot more selective about their research. Perversely, independent research firms may actually benefit from this," he added.
One brokerage official warned that some firms won't be serviced if they can't pay hefty research bills.
"So let's just say that Lehman felt that $7 million wasn't enough. Then it would stop responding to calls from Fidelity managers," the executive said. He added that many sellside shops are already under this kind of pressure.
"Right now there is no transparency as to what you have to do to get paid. So what happens is the sellside is constantly trying to stay in front of pms and analysts as much as they can, trying to create a real value proposition," the brokerage executive said.
"So these people," he added, "will start to say, that we can't service you because of the amount of commissions you're no longer sending to us."
The bulge-bracket firms, this executive also said, will tell smaller investment companies that their portfolio managers don't generate enough trading revenue. So they will be denied access to their prime research. And without their research, the scenario goes, fund managers will fall behind. Their performance will lag and that will show up in assets under management, the mother's milk of the fund business.
Buyside Woes
On the buyside, forcing firms to pay research bills out of operating expenses will likely reduce profit margins. This could force out smaller asset management firms, which the Tabb Group recently defined as firms with assets of under $50 billion.
Many smaller buyside firms with little or no in-house research capabilities or ones that would have difficulty paying for research in cash could have trouble competing, industry observers said. These firms aren't equipped to obtain the lowest commission-only trading rates, sources say. They could soon be swallowed up as consolidation swept the business in the wake of the triumph of unbundling. Again, this is an eventuality that Pickard, an attorney in private practice representing soft dollar brokers, said is "unlikely to happen." Nevertheless, even though he insists there is little chance of unbundling sweeping the business, Pickard said it would have a destructive effect on the trading industry.
"There would be downward pressure on research," according to Pickard. "There would be great resistance to paying for research in hard dollars. It is always easier to pay for research in commissions," he said. Any rules stipulating unbundling would be onerous, Pickard said. "It would be too complicated to do. It would be very costly and of no purpose," he said. Unbundling, Pickard agrees, would mean fewer commission dollars to go around.
With firms paying for research in cash, buyside firms will have to justify every cost, warned ITG's Killian.
"Everyone is now going to be probing for the quality of research that is received," he added. "If the buyside firms have significant research staff, people will ask why they are paying for outside research?"
Fidelity's decision, several trading officials told Traders Magazine, will inevitably mean money manager consolidation. That's because many firms won't be able to pony up the amounts of cash for research that Fidelity can.
"This (unbundling) will kill the small managers, who will be gobbled up by the bigger ones who have leverageable internal research departments," said one buyside executive who declined to be identified. "And the same thing will happen on the sellside. There's no way you can have 15 bulge-bracket firms with research departments. Seven million dollars is not a lot of commission dollars," he warned.
Average brokerage costs under the unbundling model would dip. Analysts suggest brokerage costs are now about 2.5 cents per share instead of a nickel, This will result in lower expense ratios, and more competitive funds, analysts suggest. Killian said this will inevitably lead to industry wide unbundling.
"What competitor is going to sit out there and just let Fidelity have a 10 or 20 basis point advantage?" he asked. CIBC's Worthington speculates that unbundling is not likely to come from the SEC. "At this point, change is more likely to come from the asset management industry itself."
The issue has divided the fund industry. Some Investment Company Institute members have privately complained that the end of these unique commission arrangements could put them out of business. Few investment companies wanted to comment publicly on Fidelity's move. Putnam, Merrill Lynch and Alliance Capital spokesmen all declined comment on the SEC release and Fidelity's decision.
Few trading officials would also publicly comment for this article. That's because the industry is unsure to what extent unbundling will occur, said one trading official.
"But obviously what the biggest companies do will be critical," he added.
Cox on Soft Dollar Abuses
The Securities and Exchange Commission's recent guidance on the use of commissions by the buyside is only the first step in a set of expected new rules. The interpretive release is, in part, a reaction to commission abuses, according to the nation's top regulatory official. SEC Chairman Christopher Cox recently complained of the "breathtaking audacity" in the use of alternative arrangements previously known as soft dollars.
"We have seen soft dollars used to pay for membership dues, professional licensing fees, office carpeting, and even entertainment and travel expenses," Cox recently said in a public statement.
Cox said the standard will be restricted to "advice, analyses and reports that have intellectual and informational content…" That does not include operational overhead expenses such as "computer hardware or the salaries of research staff," he added.
Under this standard, communications related to execution, clearing and settlement of transactions and other incidental functions, such as connectivity between the money manager and the broker dealer, "are eligible for the safe harbor," according to the SEC.
Will Hedge Funds and Asset Managers Pay?
Unbundling would have a dramatic effect on much of the asset management industry, but little effect on the hedge fund sector. That's the opinion of a CIBC World Markets report. There should be little change in the way hedge funds pay for research. That's because "their customers care more about alpha generation than costs," according to the report. But the asset management business's smallest players would be hurt if unbundling moves ahead. The cost of research at these smaller firms could add up to 3 percent to 5 percent of revenues. "Small mutual fund managers," the report said, "are already buried in compliance costs and could throw in the towel."