In Dispute Over Commission Sharing, SEC Opinion Could Force Bulge Brackets' Hand
August 25, 2008
The Securities and Exchange Commission will soon clarify how compliance conflicts can be avoided when institutional investors pay brokers for services that are "unbundled" from execution costs. That guidance could help resolve issues around commission-sharing arrangements (CSAs), as some of Wall Street's biggest firms are refusing to accept payments from the programs.
Paying for brokerages' unbundled services, which range from research and trade analytics to capital introduction, has been a hot-button issue for bulge-bracket firms for several years.
New York-based agency broker Instinet was one of the first firms to establish a CSA program--BrokerShare--allowing clients to accrue trading-commission credits by using its global execution services. Those customers then direct Instinet to pay brokers and other participants for services, including research, that are eligible under Section 28(e) of the Securities and Exchange Act of 1934, which enables money managers to generate commission dollars to pay for such services without violating their fiduciary responsibilities.
Instinet, a Nomura Holdings subsidiary, sent its first BrokerShare payment in January 2003 and currently issues checks to around 225 brokers for 110 buy-side clients, roughly 65 percent of whom are hedge funds, according to Michael Plunkett, president of Instinet North America. "The only people unwilling to take checks are the bulge brackets," said Plunkett.
Declining to accept payment from CSA programs would appear to work in the biggest firms' favor. CSAs have benefited smaller players by enabling wider distribution of their services, but the bulge-bracket firms already have that distribution. In addition, top-tier firms have made huge investments in their trade-related services and are now reaping the rewards. Institutional customers who don't see the value in making usage of a firm's services dependent on sending it orders can always go elsewhere, or use cash--so-called hard dollars--for payment.
Large investment managers such as Fidelity Investments are increasingly seeking to use hard dollars, in an effort to lower their unbundled commission rates. But paying for services through commissions--soft dollars--is a long-established practice with significant conveniences, and many clients see value in trading at the firms whose services they want.
Goldman Sachs' equity analysts, for example, have long topped the rankings, and the firm has few peers in technical and market expertise. However, Goldman doesn't accept CSA payments for those services in the U.S.--customers using commission revenues to pay for Goldman's services must trade through the firm. Goldman's reputation as an elite trading institution is indicative of the value investors have placed on its related services, as is the growth of Sigma X, its internal matching engine. Through the first half of 2008, Sigma X--the largest dark book--saw its matched volume rise 46 percent, according to Tabb Group.
Credit Suisse's CrossFinder dark pool grew by more than 100 percent during that period. Respected for its research and trading technology, Credit Suisse also declines to accept CSA payments. A few agency platforms, such as the Bids Trading and Level dark pools, have also experienced significant growth this year.
Compliance Conflict?
Despite the strong business rationale, brokers who decline CSA payments tend to point to potential conflicts with the Investment Advisers Act of 1940, which classifies brokers who accept checks as investment advisers, resulting in significant compliance demands. "We've decided, from a compliance standpoint, that we're not going to be taking checks from third parties," said UBS head of trade execution Timothy Gee, who acknowledged that his firm sends payments to brokers through its CSA program.
