Comment: Unbundling rules will get tougher

The most dramatic change to equity markets since deregulation in the 1980s may be driven not by high-frequency trading, dark pools or fragmentation, but by a long-overdue overhaul of the way fund managers pay brokers.

Most fund managers use clients’ assets to pay for a diverse array of broker services from which they directly benefit — a custom sometimes known as bundled commissions — and this gives rise to an array of conflicts of interest.

That too few fund managers have sufficiently rigorous processes to govern what they consume and how much they spend using commissions has been a longstanding concern. Previously overlooked by European regulators, the topic of commission unbundling has risen to the top of the agenda.

The UK has led the unbundling debate, but until recently the cat-and-mouse game between the industry and regulator has been ineffective. The now-defunct Financial Services Authority was sold a pup when commission share agreements were proffered by the industry as a solution to the failings highlighted in the Myners report of 2001.

CSAs enabled fund managers to argue that they were separating payment for executing trades from payment for research, but they are not sufficient to determine the value of services consumed, nor control spending.

To say the industry was inept at commission management would be an understatement. When CSAs were first adopted some fund managers actually failed to spend all the commissions they had accrued in their CSA accounts with brokers. Legally the money belonged to the executing broker, so at the end of the year they had no option but to bank it. This should have set the regulatory alarm bells ringing and mark the end of the CSA experiment. It did not.

Instead the FSA moved to tighten the definition of the services that fund managers could purchase using commissions, some of which it transpired were more honoured in the breach than in the observance.

Finally the FSA commissioned an independent report from Oxera, which it published in 2009. Although this was unsatisfactory in many respects, the FSA cherry-picked from the results and concluded that because CSAs had increased in number, unbundling was no longer a matter of concern. Job done.

The rude awakening came in 2012 when the new Financial Conduct Authority found the industry still seriously wanting with respect to how it used commissions and managed conflicts of interest. Perhaps intent on avoiding the mistakes of its predecessor, it quickly concluded that it would be simpler for all concerned if payment for broker research was treated as a cost to the fund manager rather than paid for out of client funds.

It is hard to find a cogent defence of the current regime. Brokers have issued research reports arguing that the return on equity of fund managers will be ruined if they bear the costs of research, thus demonstrating how little they understand their clients — and how impoverished broker research can be.

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Possibly the most valid objection to any change — that the UK’s competitive standing would be undermined were it to act unilaterally — was significantly addressed last year when the FCA encouraged a pan-European approach to the unbundling problem. To the surprise of many, the European Securities and Markets Authority, the pan-European regulator, adopted an equally rigorous approach to the purchase of research as part of the Mifid 2 inducement provisions.

Esma’s advice is that fund managers should either pay directly for broker research and adjust their management fees accordingly, or continue using client money to do so but only if they implement rigorous controls and a detailed contractual agreement with each underlying client, arguably making such an approach prohibitively complex.

The direction of regulatory travel is consistent and clearer than before, and the unbundling debate is a small part of a trend demanding higher standards of control, governance and cost transparency from fund managers. Those who await Esma’s next line of printed text in the hope that it will give some wiggle room, or that by enhancing the CSA model it could somehow be business as usual, are deluding themselves.

The simple fact is that the FCA requires fund managers to demonstrate appropriate governance and controls around commission spend at the very least.

Those who think this can be achieved without pricing research, receiving and paying invoices for corporate access, and dispensing with the arcane broker vote must have a very high appetite for regulatory and reputational risk.

Richard Balarkas is an independent consultant and the former chief executive of Instinet Europe