U.K. trading commissions rise as banks quit programs

LONDON — Trading commissions in the U.K. are edging higher as leading international investment banks UBS, Lehman Brothers, Merrill Lynch and HSBC have withdrawn from commission recapture programs.

The increase is despite the guidelines introduced last year by the Financial Services Authority requiring greater disclosure by money managers of research and execution costs within trading commissions in the U.K.

Commission management specialists said recapture activity has been falling in the U.K., but they had expected commission costs to fall as well now that money managers are required to report execution and research costs to clients.

Commissions might only be a small part of overall trading costs, but every basis point counts when pension plans are searching for alpha, according to David Morgan, chief executive of Coal Pension Trustee Services, Sheffield, England, which is responsible for £24 billion ($47.2 billion) in pension assets for Britain's coal industry.

At the end of June, commission costs in the U.K. averaged 14 basis points, compared with 13 basis points a year earlier, and 12 basis points at the end of June 2004, according to recent data from Plexus Plan Sponsor Group Inc., Bethesda, Md. Total execution costs were 71 basis points June 30, compared with 44 basis points at the end of June 2005.

The data include both full-service and execution-only trades and all equity classes traded in the U.K. for Plexus clients, said Steve Glass, manager at Plexus.

Zurich-based investment bank UBS AG withdrew from commission recapture globally last June, said spokeswoman Sarah Small. Lehman Brothers Inc., New York, withdrew from global commission recapture in January 2006, according to spokesman Mark Lane. Alexandra Walker, spokeswoman at Merrill Lynch & Co., London, declined to comment for this article, and representatives of HSBC Bank PLC, London, were unable to comment by press time.

Commission management sources are concerned that pension plan clients have less control over negotiating dealing commissions as the largest brokers exit recapture programs. Brokers not participating in recapture programs might have more freedom to gradually increase commissions without clients looking over their shoulders, they said.

In a commission recapture program, a plan sponsor asks its money managers to trade a portion of its securities through one or more specified brokers. These brokers will then charge a lower rate for executing trades and the excess commission will be returned to the plan sponsor, rather than being used by the broker or fund manager to pay for research and other services.

"It would seem that brokers are raising the cost of full-service execution" to offset shrinking margins caused by a sudden jump in the use of execution-only business and electronic trading networks, said Todd Burns, president of commission recapture specialists Lynch Jones & Ryan, New York.

Chris Angell, a principal at Mercer Investment Consulting, London, said he was dismayed to see recapture activity falling as commissions edged higher. Commission costs of 10 to 15 basis points indicate there is still considerable commission the client could recapture, he said.

Some U.K. pension plan clients are considering increasing commission recapture or moving to execution-only transactions, benefiting a number of "second-tier" brokers, he said. However, those brokers can't fill the gap left by the departure of the large brokers.

Ian Toner, newly appointed head of commission management at Russell Investment Group, Tacoma, Wash., said, "As less commission is recaptured, we would expect commission rates would have dropped rather than risen" because ideally, falling commission rates would mean less commission to be recaptured. He said the increase in commissions made a strong case for continuing with recapture programs, and he is confident those brokers that had withdrawn would soon return to it.

In an e-mailed statement, Sarah Small, spokeswoman at UBS, said the firm decided to stop commission recapture "in the interests of transparency and fair treatment of clients, as well as a desire to compete on an equal footing with our peers, some of whom did not participate in this practice. It was also made in the light of continuing falls in commission rates, the increasing use of execution-only trading channels and the erosion of the original commercial principles underlying the practice."

Neither LJR nor Plexus had data to show the increase in either execution-only trades or the decline in commission recapture activity in the U.K. But Messrs. Burns and Glass both said there is considerable anecdotal evidence that this was the case and that brokers were stopping commission recapture programs as their internal margins had shrunk.

LJR's Mr. Burns said he had seen a fall of up to 75% in commission recapture activity among the firm's clients in the U.K. The decline in use of commission recapture was far more dramatic in the U.K. than in the U.S., where clients are more diligent about the commissions they pay, said Plexus' Mr. Glass.

Mr. Burns believes brokers and money managers have been working together to keep control over client commissions after the FSA disclosure rules were introduced last year.

"Call me suspicious, but I think this was cleverly worked out beforehand to eliminate the commission recapture broker and the need to return money to the client," said Mr. Burns. "The loser is the investor," he added.

Since 2005, a number of brokers have been negotiating harder to retain a larger slice of commissions in recapture deals in anticipation of increases in execution-only trading, said Mr. Burns.

Rather than participate in commission recapture, some large brokers such as UBS have set up commission-sharing arrangements where client commissions are held by the broker and divided into separate pools to pay for execution fees and research costs. Money earmarked for research costs is controlled by the broker, which then pays either internal or external sources as necessary. Unlike commission recapture, no funds or credits are remitted to the client.

Mr. Glass said recent reports from money managers trading in the U.K. showed execution costs were between eight and nine basis points. Research costs were reported at between six and 10 basis points.

In the U.S., many brokers run commission-sharing arrangements alongside commission recapture programs, said Mr. Burns. He sees nothing wrong with these CSAs but believes they should not be seen as a substitute for commission recapture.

"CSAs appear just the same as soft-dollar arrangements as the money managers again get the full use" of the commissions, he said.