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Magazine Issues » Dec 2008-Jan 2009

COMMISSION RECAPTURE: doomed to extinction

Brokers and asset managers may argue that clients’ wishes for best execution are better served without the complication of commission recapture. Nicholas Pratt asks what this would mean for pension funds...

Commission recapture should no longer be deemed a relevant service in today’s unbundled market – at least as far as many fund managers are concerned. The practice of receiving rebates from brokers on their commissions was once commonplace in Europe for pension funds and it still is popular in the US.

But from 2005 onwards a growing number of large brokers have withdrawn their participation in commission-recapture programmes.
One of the main arguments for this withdrawal is that the  unbundling of brokers’ fees and commissions has led to greater transparency and, in turn, lower commissions and more execution-only trades. Pension funds, it is argued, no longer need commission recapture.

“Unbundling has focused managers in particular to scrutinise what they are paying their brokers for and whether they are getting value,” says Liz Rae, senior adviser, investment and markets, at the UK’s Investment Management Association (IMA). “Anecdotal evidence would suggest that commission rates have fallen since the disclosure regime was introduced into the UK.” 

But commission recapture agents argue there is still not 100% transparency or unbundling and so retaining their services will act
as a potential penalty for those asset managers who fail to trade efficiently.

Chris Angell, principal at pension consultancy Mercer Sentinel Group, says: “Commission recapture is still relevant. When there is complete unbundling and execution-only deals then it may be a different case, but we are not at that point yet.”

Angell says that asset managers and brokers have tried to “kill the beast” of commission recapture in Europe and have been hiding behind commission-sharing agreements, arguing that it is impossible to try and run both. He feels that commission recapture still has an important role to play in pushing the industry to get to the point where pension funds can fairly claim to be in control of their own trading.

“Yes, there is more transparency and yes, there are more execution-only trades. But these are two steps and not the third and final
step: pension funds want to be able to control their own trades,” says Angell.

Angell accepts that the ongoing participation of brokers is critical to commission recapture. “Commission-recapture agents must have a good correspondent brokers’ list or else asset managers can turn around and say they are not going to deal with third-tier brokers,” says Angell.

“Some custodians have become reactive rather than proactive in ensuring they have top-tier brokers involved in their commission-recapture programmes. The agent is remunerated for the business they get so there is an additional revenue stream for them. But perhaps there are those custodians that see it as a dying industry and are not prepared to put any effort in. I think this attitude is premature.”

BNY ConvergEx, an agency brokerage and affiliate of BNY Mellon, is one of the few firms to have invested in commission recapture in the last few years. It acquired LJR Recapture Services (formerly Lynch, Jones & Ryan) in 2005 as part of its bid to ramp up its business with global pension funds.

Carey Pack, chief executive of BNY ConvergEx Execution Solutions, cites the rise of execution-only brokers as one reason that recapture has become less widespread. “One of the main benefits of commission recapture was converting a percentage of pension funds’ business to execution-only so that they did not need to pay for full-service executions and the cost of research. Now we are seeing more electronic execution-only brokers and reduced commissions, which are good things for our clients. But there is still a role for commission recapture in encouraging pension funds to ensure they get the best quality of execution.”

And therein lies the dilemma for commission-recapture agents. The goal is to ensure lower cost and better quality execution for pension fund clients, but as this goal becomes more of a reality – with execution-only brokers, reduced commissions, unbundling and the likes of MiFID with its guidelines on best execution – the less need there is for commission recapture. “From a theoretical point of view that is right but the market does not operate that efficiently,” says Pack. “People have been saying that we no longer need commission recapture but we still continue to play an important role for pension funds.”

Although Pack admits that the absence of most of the global sell side brokers from recapture programmes does give less choice to fund managers, he adds that there are new brokers joining his programme, albeit more specialist and regional brokers. One thing that has not changed though, is fund managers’ reluctance to be dragged into commission-recapture programmes.

“Of course they would rather have complete control but that is not always in the best interest of their clients and it is their
clients’ commission.”

Russell Investments has become one of the most active proponents of commission recapture. While brokers and asset managers may argue that clients’ wishes for best execution is better served without the complication of commission recapture, Russell believes that this is not the case. “Commission recapture reduces cost for the client, but does that make it part of best execution? We think it does,” says Ian Toner, head of commission management at Russell.

“The core mechanism is the broker review process from the asset manager. It could be seen as an instruction from the owner and end-investor. If you look at the Financial Services Authority’s guidelines, a core element was supposed to be regular conversations between asset owners and asset managers over services demanded and services paid for and commission recapture is explicitly mentioned.”

Economic value
“The client is asking for the minimum, not the maximum, participation,” says David Rothenberg, managing director at Russell. “As an asset manager, have you done a better job with a broker outside a commission-recapture programme and can you prove it? It is a question of economic value.”

“The reality is that commission recapture is not about an absolute level of commission, it is about proportions and ensuring that the value generated by a pension fund’s order flow goes back to the owners of that flow,” says Toner.

This is the central point of commission recapture in today’s market – that it becomes a tool to reflect the collective bargaining power of pension funds.

“Trade flow has become much more valuable to brokers and we feel that the original owners of this flow should be rewarded,” says Toner.

Nevertheless, fund managers and brokers will still complain that commission-recapture agents are an unwanted irrelevance in today’s markets. One broker says: “If the likes of Russell’s commission-recapture programme became more widespread, brokers’ rates would go up to compensate. We are used to negotiating with our clients and we do not need a third party butting in to increase the cost of commissions.”

©2008 funds europe