Transparent Bundles Part I

Transparent Bundles

Open network access has vitalized the argument for transparency. This seems to be playing out across a number of key economic sectors: in software, the rise of Linux is forcing Microsoft to unbundle its suite of systems and applications and charge on an a la carte basis; on the Internet, cheap access has forced AOL to justify each component of its service; and in the institutional investor world, which is what I focus on, electronic access to liquid markets is forcing brokers to break down the costs of their bundled commissions.

When dealing with brokers, investors are typically led to ignore pennies and instead focus on the notion of added-value. After all, what Merrill Lynch, Morgan Stanley, Goldman Sachs and others do is far more than simply execute trades. They provide liquidity and anonymity for execution. They provide prime brokerage services, access to capital and provide allocations of IPO shares. They offer conferences and set up one on one interviews with company management. They also produce research, reams and reams of information and analysis on thousands of companies and sectors around the world. For their best clients, they even procure tickets to events, restaurant reservations and golfing and skiing trips. All of this adds up to millions of dollars in value, or so investors are led to believe. All of these components are integrated into a single unit of value, otherwise known as the commission price. Typically, this is about five pennies per share.

If you were walking quickly down a busy street and came across four pennies, would you pick them up? This is roughly the spread between a typical bundled commission and what it costs to simply execute a trade. The difference is supposed to account for the range of value-added services described above. Brokers do not readily break down the relative price of each component bundled into this commission. Investors, meanwhile, are so used to the convenience and perceived value of the bundled commission so as to not question brokers' opacity.

At least until now.

On Monday, March 15 2004, Fidelity wrote plainly to the SEC:

The bundling of research and execution is the least transparent aspect of transaction costs, and the Commission should not do anything to favor it over other uses of commissions to obtain legitimate benefits for the adviser.

A number of other mutual fund complexes are racing to stand on the same transparency platform by banning soft dollars entirely and paying for each service out of their own management fee pocket. Even Morgan Stanley, a broker nonetheless, has come out to say it will stop accepting soft dollar commissions.

Soft dollars are clearly in line for increased transparency. I am not sure if anybody really benefits from a full ban on them, which seems like excess grandstanding among those accused of impropriety. Still, the increased scrutiny on transaction costs on behalf of investors is a good development of late.

What is not ok, however, is if in the context of more closely investigating soft dollar commissions and the related payments to third party research providers, that investors dont look equally closely at commissions that combine trading and execution at full service brokers. In its letter to the SEC, Fidelity argues that:

...we estimate that research bundled with execution represents a larger share of commissions than third-party research, and we expect this would be true at other firms as well. Thus, in addition to giving rise to competitive unfairness for third party research providers, quantifying third party research without quantifying bundled research would significantly understate total soft dollar use and could be highly misleading to investors. (see full article here)

Here is where the rubber hits the road and where, in circuitous yet logical fashion, Fidelity's words threaten everything from restaurants to residential real estate in most financial districts- specifically New York. The fact is that soft dollars and bundled commissions are the vig that generates much of the wealth among the brokerage industry in New York, which in turn lubricates expense accounts at lunch time and grand Park Avenue co-ops and East Hampton beachfronts. Is it not ironic that New York has a mayor whose namesake company benefits more from monthly soft dollar payments than perhaps any other financial institution. In a way, Bloomberg has taken the notion of value-added brokerage services to the peak of civic duty. Our city itself reflects the residual value of opacity in financial markets. And so the question comes back to what happens to the brokerage industry when transparency become of more value to investors than opacity? And how will independent research firms and execution only trading platforms emerge to service these needs for increased transparency?

Comments

[Posterboy]

Soft dollars clearly aren't going away as a means of paying for equity research in the short term, though who pays soft dollars and how is evolving. As Seth notes, a number of large mutual funds have said they will no longer pay soft dollar commissions and the SEC is taking a closer look at various payment practices. One of the clear long-term questions for independent research providers is, "how will I get paid for providing research in a changing market, and what payment method do I build and scale my business around?" It's unclear, but maybe a two tier market will develop -- large mutual funds and hedge funds who can afford to pay hard dollars, and hedge funds and smaller asset managers who continue to pay with soft dollars.

Charging a $50K annual subscription is a nice way of building a niche business, but ultimately not scaleable (ie, at a 100 paying customers, you're only generating $5 MM in revenues a year). The real "leverage" in the independent research world comes from soft dollar commissions (ie, you can generate that same $5 MM in revenues from 2 hedge funds who like your ideas and direct trades to your desk). Independent research companies will have to figure out how to balance a paid hard dollar model which might not be that lucrative (unless the research is absolutely stellar) with a soft dollar model providing custom research to a few select clients.

Analysts peg the size of soft dollar commissions paid at anywhere from $1bn to $10 bn annually. Nobody has ever tracked the size and its hard to distill true soft dollars from hard dollars as money and relationships are fungible. It's reasonable to say that at some of the multi-billion hedge funds that trading commissions can total $50-$100MM, most of which get divyed up when portfolio managers take a quarterly vote on whose research and execution has been the best. Maybe this is the primary market to go after, particularly if mutual funds shun soft dollars and the hedge fund world remains unregulated.

[Druce Vertes]

It almost sounds like you're saying banks like Goldman Sachs will become less dependent on commissions, and more on proprietary trading, services to hedge funds, and owning the new companies that enable the distributed investment supply chain, like Archipelago, Eze Castle etc.

http://news.ft.com/s01/servlet/ContentServer?pagename=FT.com/StoryFT/FullStory&c=StoryFT&cid=1079419957803&p=1012571727088

I agree with the essence of the comment, that sell-side research is being restructured. This is because the research cost structure post-1999 is out of whack, and also due to the trend toward deconsolidation or dis-integrating the vertically integrated banks, not to mention new distribution technology.

But you almost make it sound like it spells the end for GS and Alain Ducasse. In fact, they're hardly hurting these days, and research-driven commissions are far from the banks' main business models. If commissions are lower and more transparent, and more research is done by independent firms and the buy side, and (God forbid) investors who keep a little more of their money, it will mean a stronger US capital market structure, which will help NY remain the place companies like SMIC go public.

The restructuring of research to a more transparent and unbundled cost model seems to me to be part of a much broader restructuring of trading driven by platforms like Archipelago and Lava Trading, giving investors the ability to tap all pools of liquidity, including each other, and more easily bypass the big banks and the NYSE.

It's just another chapter in the shifting balance between the middlemen, who want to maximize the rent from their position, and the principals. An interesting chapter but not as significant as say, the end of fixed commissions.