EU threat of soft-dollar ban still alive, raising questions for managers

Not so fast.

The possibility of European regulations banning the use of soft dollars for third-party research is alive and well, despite talk in the U.K. and Europe that regulators would settle for something that falls short of a ban.

Trading analysts, some of whom see as much as a 50-50 chance of a full ban, say unbundling research from commissions would end an established practice among money managers, brokers and research providers of tapping commissions to pay for research. A ban would be felt in the U.S. as well as in Europe, as managers decide whether to eat the costs of research themselves, pass the costs on to asset owners and other clients, or stop buying research altogether.

“Some global U.S.-based managers say that it'd be very challenging to run a global business that meets all regulatory regimes, so they tend to manage their business to what they deem to be the highest regulatory standard,” said Tom Conigliaro, managing director and head of investor trading services at Markit Ltd., New York.

“Therefore, if the rules ... are passed as currently proposed, U.S. asset managers may choose to follow the U.K. and EU rules even if the rules remain unchanged in the U.S.”

While all U.S.-based global money managers would face hurdles as a result of changes in soft-dollar rules, the impact on midsize and smaller equity managers would be far worse, said Tim Barron, chief investment officer at Segal Rogerscasey, Darien, Conn. Larger firms would have the scale to take on the added research costs themselves, he said.

“What happens to those (smaller) firms?” Mr. Barron asked. “They need to leverage the research because they don't have the scale to pay for it direct. I think you'll hear complaints from both money managers and pension funds, since you'll be locking out smaller managers. If the SEC took action on unbundling, can you imagine the Obama administration with a rule that says bigger is better? If you're looking to get more transparency on commissions, there are a lot better ways to do it.”

Efforts to ban soft dollars for research in the U.S. fell short. “The SEC has looked at this issue at least six times already since 1975, and each time they have found that the current model supports research as a fundamental pillar to the asset management industry,” Mr. Conigliaro said.

The European Securities and Markets Authority, the Paris-based financial regulatory agency of the European Union, is still considering an EU-wide ban on soft dollars as part of Markets in Financial Instruments Directive II. That directive would harmonize regulation of investment services across EU-member countries plus Iceland, Norway and Liechtenstein. The ESMA is scheduled to issue a revised recommendation on disclosure of research commissions by March.

The U.K.'s Financial Conduct Authority, a proponent of an outright soft-dollar ban, in June implemented research commission rules that fell far short of that goal, instead focusing on mandatory valuation of soft dollars. But because a ban is on the table at the ESMA, FCA officials are still pushing for it, albeit through the European agency. Officials at the FCA couldn't be reached for comment.

“The FCA would love to ban research commissions in the U.K.,” said Neil Scarth, principal, Frost Consulting & Advisory, London. “But they know if they did, managers in the U.K. would go to the government and say that complying with that would raise their notional management fees to a significant premium over what managers pay for research in the U.S. So (the FCA) has said they're going to abide by whatever the ESMA decides. But in reality, the FCA hasn't backed off on this issue at all.”

If approved in Europe, the ban would mean a lot of shifting in how research is paid for — and how managers would cover the cost themselves. Mr. Conigliaro said the estimated annual commission cost for execution and research industrywide is more than $10 billion in the U.S. and $4 billion in the U.K. If research is unbundled, about 50% of those costs would shift to money managers, he said.

Proponents of a total ban say money managers generally don't know where the money used for research goes because soft-dollar arrangements are at best opaque, and a ban would make managers more careful about how they use their research dollars, said John Colon, managing director, Greenwich Associates, Stamford, Conn.

But Mr. Colon cited a fourth-quarter report by Greenwich that warned such a ban would eliminate commission-sharing arrangements, which “would have a seismic impact on the (brokerage) industry as a whole, since revenue generation and market share among European equity brokers are largely determined by the breadth and depth of their research arms. This has significant meaning for buy-side fee structure,” Mr. Colon said, referring to full unbundling as “the nuclear option.”

“The big question is, how do you price and value research?” Mr. Colon said. “Research goes well beyond written analysis. That's like table stakes in a poker game. Managers really want to know what analysts think; talk to them; test their ideas. You need to look at research as a process, not as a product.”

Mr. Barron at Segal Rogerscasey said he doesn't think it's a sure thing that the ESMA will go to full unbundling, citing opposition by national regulators led by L'Autorite des Marches Financiers in France.

Most money managers contacted for this story would not comment on what the impact of a soft-dollar ban in Europe would be, although many did indicate they would pay more for research if the ban were implemented.

However, Christopher Vella, senior vice president and CIO, multimanager solutions, at Northern Trust Corp., Chicago, said smaller U.S.-based managers won't be hurt.

“The only firms likely to face a significant impact would be European-based managers just starting out,” Mr. Vella said. “The investment management business in general has very low barriers to entry. Technology costs are relatively low and most trading technology companies actually work with startups to reduce costs while they are small.”

Northern Trust's multimanager program has about $75 billion in assets under management.

Theodore R. Aronson, managing principal and CIO at equity manager AJO LP, Philadelphia, said he's pleased the ESMA and FCA are pushing for a ban.

“How can you get best execution while paying someone for non-execution services?” said Mr. Aronson, whose firm manages $24.6 billion. “Soft dollars are a rip-off ... always were and always will be. ... The U.K. and the EU should be commended for doing what the SEC is too chicken to do.” n