Broking Commissions

Paul Myners made proposals on this in his report Institutional Investment in the UK: a review. The Government proposes to take this issue forward as follows.

Despite a great deal of controversy over Mr Myners’ proposals on commissions, few responses to the Government’s recent consultation disagreed with his central proposition, that these costs “which are substantial” are “subject to insufficient scrutiny” and that “clearer and more rigorous disciplines could be applied”. On the contrary, the clear message from the consultation responses is that the problem is, if anything, greater than Mr Myners originally suggested.

As respondents pointed out, commission payments are only one part of the costs of share transactions. In the view of many respondents, more effective disciplines on one form of transaction costs (commissions) could simply be offset elsewhere (for instance, through a general widening of dealing spreads). The widespread implicit assumption – that neither sufficient competitive pressure in broking and market-making, nor the present obligation of Best Execution, would protect clients from such effects - is, in the Government’s view, a matter of serious concern in itself. It does create a real danger that the mechanism originally suggested by Mr Myners might not be fully sufficient to tackle the problems he identifies.

Nor, however, does the Government agree with those responses which suggest that greater information flows to pension fund trustees about transaction costs are likely to be, on their own, a sufficient solution to the problem. Decisions about how and with whom to trade are both technically complex and highly specific to the transaction in question. Trustees are rightly distant from this sort of day-to-day decision-making. It is clear from responses by those trustees that have sought to address the issue that their ability to bring about effective pressure for change can be only limited.

Certain other aspects of the responses also suggest that the problems run deeper than lack of information alone. These include:

frequent references to cross-subsidies in the present system;
fear that clients will, should they seek to put pressure on costs, suffer in other ways (for instance, lose out in access to Initial Public Offerings); and
the evident difficulty for many institutional clients in obtaining access to “unbundled” services (for instance, separating out transaction services from research).

It is clear from the responses, therefore, that beneath the problems rightly diagnosed by Mr Myners lie competition issues of some complexity.

Like Mr Myners, the Government has a strong preference that such issues should be tackled, where possible, through market mechanisms and commercial negotiation between the parties concerned. However, this is a significant challenge, especially for pension fund trustees. The need is for structures which:

result in optimal trade-offs between quality of execution and cost, underpinned by vigorous competition in broking and market-making and proper customer pressures;
do not distort decision-making through perverse incentives (for instance, to trade in one way rather than another, or to pay for research by one kind of provider rather than another); and
do not create conflicts of interest (for instance, for fund managers to deal with particular brokers because of so-called “soft” commission arrangements).

Mr Myners has suggested one mechanism which would help, and which would represent a significant step forward from the status quo. There may, and probably will, also be others. The Government does not wish to prescribe one particular mechanism at this stage. The challenge for the pensions and investment industries is to identify satisfactory ways of achieving the aims above. As a first step, the Government has agreed with Mr Myners that he should develop a set of questions to assist pension funds in requiring better disclosure and clearer incentives for their managers and brokers. These will be included in the Government’s final response to the review, which it will publish (taking account of points made in the recent consultation) in September.

The Government will look for clear evidence in its two-year review that improved structures of the sort above are being developed. Options at that stage, should they not be, would include asking the competition authorities to examine the whole area.

The two-year review will be looking for evidence, in particular, that:

trustees have a much better understanding of the costs they are incurring, and why;

they have more effective arrangements in place, whether including direct financial incentives or not, for controlling them; and also that
the market has developed so pension funds have a fuller range of options genuinely open to them, on competitive terms and on a level playing-field, in relation to the way they procure transaction and other services, including research.

The Government’s final response to the review in September will also include an amended set of principles for defined-benefit and defined-contribution funds. In respect of transaction costs, the Government is minded to propose the following wording in place of the final sentence of principle 6:

Trustees, or those to whom they have delegated the task, should have a full understanding of the transaction-related costs they incur, including commissions. They should understand all the options open to them in respect of these costs, and should have an active strategy - whether through direct financial incentives or otherwise - for ensuring that these costs are properly controlled without jeopardising the fund’s other objectives.

The Government has also identified at this stage two further issues where progress would be helpful in achieving the desirable structures outlined above.

Soft commission

Financial regulators have rules subjecting soft commission practices of authorised financial services firms to disclosure and other requirements. In April the FSA published a discussion paper on Best Execution obligations in securities markets, including brokers’ duties to clients generally, which noted soft commission as an issue. The Government has discussed and agreed with the FSA that its study of best execution will be widened to review explicitly the regulatory requirements bearing on soft commission practices of authorised firms.

However those regulatory requirements evolve, the government is concerned meanwhile to promote close consideration by pension funds themselves – as the ultimate clients – of fund manager and broker practices on soft commissions. Such practices can blunt incentives for fund managers to manage commission levels effectively. Moreover, as not all execution methods will necessarily involve the same softing arrangements or indeed any softing arrangements at all, distorting incentives can be created to deal through one channel rather than another. The Government has been struck by the number of respondents who argued for these reasons that soft commission arrangements should be banned.

The Government therefore proposes, for the purposes of the Myners principles, that:

Pension funds should not without good reason permit “soft” commissions to be paid in respect of their transactions.

Unbundling

The second issue where progress would be helpful would be the unbundling of services provided by brokers and broker-dealers. The Government has already identified the prevalence of bundling as suggesting the existence of competition issues of some complexity. In particular, it believes that greater unbundling would facilitate the emergence of the transparent and competitive structures envisaged above. It would also, through enabling clearer price comparisons between different methods of execution, improve the ability to achieve best execution. The FSA’s work on best execution is therefore also relevant to this area, and the Government has discussed and agreed with the FSA that their work will also include examining possible regulatory change relating to unbundling.

Small schemes

Respondents to the principles have expressed concerns that it would be difficult for smaller funds to implement all the principles, and these concerns were raised in the context of commissions too. This issue will be dealt with as part of the Government’s response on the principles as a whole

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