Date : June 27, 2005
Publication : Securities Industry News

Soft Touch or Hard Line

The Securities and Exchange Commission has delayed its decision on new rules for the use of soft-dollar commissions, but that isn't preventing the industry from speculating about the possibilities--and preparing. Indeed, even if the SEC ultimately does not require unbundling of services including flat commissions, competitive pressures might force broker-dealers to do it anyway, some industry participants believe.

The market consensus is that, like the U.K.'s Financial Services Authority, the SEC will call for greater transparency regarding soft-dollar spending. But buy- and sell-side firms are waiting to see if the regulator will place the onus on brokerages to break out the price of their research from that of its trade executions.

No one believes that the replacement of SEC chairman William Donaldson with Rep. Christopher Cox, R.-Calif., will affect the outcome, although the timing concerns many in the industry. Fund managers and broker-dealers were predicting a final ruling earlier this month.

"At the very least, the SEC will narrow the definition of what research really means," says Stephen Schardin, president of Charles River Brokerage, a subsidiary of Charles River Development set up last November to enable buy-side customers to pay for the Charles River order management system with soft dollars. Schardin believes the SEC will ban items that are not research products per se, such as T1 communications lines and terminals.

In a research report released in March, Bear Stearns analysts Daniel Goldberg and Andrew Lee predicted a similar outcome but did not rule out the possibility that the SEC will unbundle commissions or demand that a hard-dollar value be placed on proprietary research, execution and capital commitment.

Under Section 28(e) of the Securities and Exchange Act of 1934, known as the "safe harbor" rule, a manager is allowed to "pay up" for a trade--accept a price inferior to the best offer on a given stock--if the manager believes the research provided by the broker will add value to the investment. Asset managers must be in compliance with the safe harbor rule in order to engage in soft-dollar transactions.

Today, bulge-bracket brokerages collect a flat commission that covers execution and proprietary research. If the SEC simply requires more transparency, the buy side will have to learn how to value sell-side research in hard-dollar terms. If unbundling is the call, the sell side will assume that burden.

Sell-Side Hell

The ramifications of unbundling would have a profound effect on the sell-side business model. "Given the decline in the commission pool, the sell side has been rationalizing research," says John Feng, a consultant at Greenwich Research. "Research budgets have been shrinking. Brokerages have to be realistic about their business and determine which accounts are profitable to serve."

Price wars could break out, resulting in increased use of algorithmic trading tools by the buy side, the Bear Stearns analysts say. If unbundling is mandated, they expect brokers "to attempt to gain share through lower pricing."

Competitive pressures may force broker-dealers to unbundle no matter what the SEC decides, according to Joe Gawronski, COO of agency brokerage Rosenblatt Securities in New York. "Between the numerous vendors now providing software that can track the assessment of broker-added value, the proliferation of transaction cost analysis tools and the buy side's focus on lowering expenses, we expect the trend toward unbundling to increase," Gawronski says.

He expects the chief beneficiaries of unbundling to be agency brokerages, algorithmic trading providers and crossing networks. "A greater focus on execution quality and lower transaction costs--including commission rates--will make these types of providers look a lot more attractive," he says.

The Research Lurch

In any event, broker-dealers will almost certainly be compelled to improve research analyst productivity and shrink their technology costs. Such an approach would prepare them for both eventualities: a hard-dollar environment, if it arrives, and competition-driven unbundling if and when clients start demanding it.

Technology costs may be the most overlooked part of the issue. "Research production remains highly resource-intensive," says Allan Rosenstein, a partner with the Capco consultancy in New York. "Many firms still use antiquated templating technologies that are difficult to maintain and highly inflexible. The tools are not robust enough to capture the metadata required to distribute the research to a growing list of destinations. As a result, the proper metadata needs to be added, many times manually, on the back end."

Tech costs may also be fairly easy to handle. Rosenstein recommends that broker-dealers adopt the research information extensible mark-up language (RIXML) standard, designed to streamline the publication and distribution of research.

Buy Side: Value Quantified

The buy side, meanwhile, is scrambling to get processes in place to ensure it can track trading commissions and come up with a way to value research in case it gets stuck with the hot potato.

Buy-side firms often conduct a "brokers' vote"--an internal survey in which a firm's portfolio managers, analysts and traders qualitatively rate the value of services provided by brokers. The result is taken into consideration in setting commission targets for each broker. A poor rating may move a broker into a lower tier of the commission structure.

Because those ratings are not quantitative, the buy side is now scrambling to get technology and processes in place to track commissions objectively and calculate a dollar value for research.

Buy-side order management systems from suppliers such as Charles River, Macgregor, Linedata Services and LatentZero are able to record the commissions on each trade, and buy-side firms can use them to tag their trades and sort them into various "buckets."

There are also specialized commission-tracking systems such as Eze Castle Integration's Commission Optimizer, Financial Sockets' BrokerVote and Cogent Consulting's ResearchTrak. These are designed to bridge the gap between quantitative and qualitative measures, enabling the buy side to compare actual trading commissions against soft-dollar targets.

Boston Company Asset Management, for example, has adopted the Eze Castle product. "We had to go beyond having an anecdotal, subjective assessment twice a year that didn't integrate the actual interactions we were having with brokers and the inputs we were using as part of proprietary research," explains David Brooks, the firm's head trader.

AIM Investments, meanwhile, has licensed Cogent's system to track proprietary research down to the detail of a specific report, meeting, conference or publication. AIM uses the analyst performance database of San Francisco-based StarMine. Each analyst is ranked in relation to their peers in a given sector or firm.