The Securities and Exchange Commission is expected to require the buyside to deliver more information about its use of commission payments.
That's giving commission management software vendors both a boost and a headache. Systems that can deconstruct a commission payment or assess the value of a broker's services will be much in demand over the next year, according to vendors.
"There will be a growing need for these systems," said Stephen Parker, chairman of the U.K.-based vendor Rontech. "We must have systems that will drive down the cost of alpha," added Ellen Hunt, chief executive of Financial Sockets.
Still, some of the players in this business will be challenged to find solutions to the complexities of commission management.
"Until the regulators make absolutely clear what they require, we're going to have problems," Parker said. Rotech is one of five commission management software compliance vendors that are scrambling to help the buyside keep up with a fast changing regulatory environment.
The SEC, which last year issued an interpretative release, has promised to release new commission disclosure rules this year. These are expected to spell out how much detail money managers must give their clients regarding how their commission dollars were spent. A gaggle of vendors is promoting software for the buyside that they claim provides more effective commission tracking.
The Basics
Commission management applications generally include features such as broker evaluations. These are used by fund managers who want to know how and why their commission dollars are distributed. Brokers with the best research receive the highest commission allocation.
Commission management software also provides fund managers with the ability to monitor actual commission spending and to compare it with what was originally budgeted for each broker. Reporting consists of broker scorecards. Client soft dollar reports and commission management reports are included in the reporting sections.
Three factors-both regulatory and market related-are increasing the demand for these specialized commission management systems offered by Rontech and others.
First, the regulators in the United Kingdom are tightening the rules governing the use of commissions and broadening disclosure requirements. The U.K.'s new tougher disclosure requirements-rules that clarify how and where commission dollars are spent-went into effect this year. The SEC recently tightened its guidelines that define what can be paid for with commission dollars. It is expected to issue new disclosure rules later this year that will be "compatible" with the FSA approach. That means documenting how commissions are split between research and trading.
Second, giant money manager Fidelity Investments has been pushing brokers to unbundle.' This means that Fidelity pays separately for research and transaction services. Hard dollars are paid for research and reduced commissions for executions. (See Traders Magazine, December 2005).
Unbundling has raised questions about the value of research and increased the demand for commission tracking services. Some of those questions are posed by fund companies looking to lower expense ratios as one way of achieving better returns.
Third, some buyside commission management systems are flawed, according to several vendors. They may not meet the SEC's new commission disclosure standards.
Firms Not Prepared
These systems are now providing "only the bare legal minimum requirements," according to Philip Potasiak, the chief executive of vendor Skychange, which is based in Irvine, California.
Indeed, a study by Financial Insights, a consulting firm, declared that many buyside firms are "ill-prepared" for the new commission regulations.
"Firms are going to have do something and soon," said Randy Grossman, research manager for global capital markets at Financial Insights and the author of the report. Many commission-tracking systems are primitive, the report said.
"Sometimes, administration and record keeping consist only of a spreadsheet or two. Sometimes, it is just the bare minimum required to complete the SEC's Form ADV requirement," Grossman said. He identified five small, privately held vendors, as offering these services. They are Cogent Consulting, Financial Sockets, Rontech, Skychange and Eze Castle Software. The latter is the only OMS vendor battling in this arena.
Financial Insights identified Cogent as a leader in this market because its products have "depth." It noted that it just introduced a product for hedge funds, HedgeTrak.
Financial Insights estimates the market for commission management systems will be between $68 million and $114 million over the next year.
But, while Financial Insights believes there is an opportunity with the buyside for vendors over the next year or two, the opening for new sales will be brief.
"There will be a short window of opportunity (12-24 months) for commission management application vendors to capture market share as fund managers rush to comply with the new rules immediately before and after they go into effect," according to the Financial Insights study.
After that period, this would likely be a relatively slow-growth segment, according to the study. The study also predicted that, once a buyside firm selects a solution, it will be unlikely to change vendors.
Vendors' Woes
Part of the problem vendors face is how to design systems whose functions may be outdated in just a few months as regulators look at more and more rules and potential reinterpretation of existing rules. Another problem is that some vendors are not prepared for the more rigorous FSA standards.
"It's clear that when you have a fund or pension board that sees the unbundling standards required by the FSA, that they will insist on the same," Financial Sockets' Hunt said. But new regs could also be a problem, another vendor executive warned.
"How the FSA will interpret the new rules is something we're still waiting to see." Rontech's Parker said. For instance, in the U.K., it is the fund manager's responsibility to ensure that trading and research dollars are broken out.
"Will the SEC," Parker asked, "go that route and require the buyside to do the same in the U.S.? Here in Britain, managers insist that is a sellside responsibility."
Parker argues that Rontech's 4TEUS system-because it operates as an ASP, not an Oracle application-is unique and gives him an advantage. He said it has a flexibility that can react to myriad changes. "Any change we will make will be instantly available to every customer," he said.
With an ASP, the software is kept on the vendor's premises. It is not installed at the user's site. That makes it easier and faster for the vendor to keep it up to date.
Parker added that both the top executives of the buyside and the sellside have a stake in more commission disclosure. "The top of the sellside wants to find out what is being paid for sales, trading and research," he said. But buyside executives also don't want disclosures that upset "their rainmakers," good brokers who help them make money.
Favored Brokers
The trading industry, in this environment, will have to change a culture in which fund managers have wanted to reward favored brokers, Parker said. "This has created a conflict of interest between best execution and finding the most efficient way of trading," he added.
But regardless of how the new regulations play out, a vendor said effective commission management systems will have to be comprehensive.
"The market is going to be looking for vendors with a wide variety of services," according to Robin Hodgkins, president of Cogent Consulting, which offers ResearchTrak. These features should include a configurable front end, electronic audit trails, broker contact trackings, flexible voting criteria and user-defined comments, according to Hodgkins. But he said many of the vendors may be too small to offer all the required functions.
Hodgkins said only his firm and Eze Castle are offering a comprehensive package of software commission management products. He said many competitors are small and are only concentrating on the broker review process. Financial Sockets' Hunt rejected the criticism.
She noted that the company's BrokerSelect product has been able to provide the Level II reporting as required by the Investment Management Association (IMA), a trade association for funds in the United Kingdom.
Still, the Financial Insights report found that all of the vendors will have some problems in coping with a new commission environment. For example, the consultant named Cogent Consulting "the key player" in the business. It praised its flexibility, noting it offered clients a "front-end configuration that has the look and feel of the fund manager's own Web site."
But the consultant cautioned that, while Cogent's ability to customize systems is a benefit, customization generally "comes with premiums attached to it-both in terms of price and time to implement," according to the report. The report also notes that Cogent, one of the bigger players with 13 employees and some 30 clients, must "grow staff" to keep up with its new business.
Financial Insights also noted that a smaller player, such as Financial Sockets, is concentrating on the broker review process.
"If all you do is broker review, it's pretty much the same as serving someone a steak without any vegetables, drinks or napkins," Hodgkins said. "Any good system must go far beyond broker review." He added that only Eze Castle presents a formidable challenge to Cogent
"I just don't see these other vendors around," Hodgkins said. For a system to cope with the coming challenges, it must have at least three modules: the broker evaluation or voting, commission management and reporting, Hodgkins said.
"I believe the most important aspect of any system is the commission management part," Grossman said. "This is the part of the software where the fund manager tracks where all his commission management dollars are going and how he is allocating his mixed-use commissions."
"Mixed-use" commissions are commission dollars that are used for both research and non-research purposes. For example, computer hardware-before the latest round of SEC soft dollar changes-had both research and non-research purposes. Therefore, it used to qualify for a soft dollar expenditure. That's provided a firm had a rationale for research expenditures and it had an effective commission management system.
With the SEC and the FSA tightening mixed-use rules, most vendors expect there will be a bigger opportunity with small firms for their software systems. That is because few buyside firms have the resources to design such extensive commission monitoring systems, Grossman added.
Potasiak named Fidelity Investments and Deutsche Asset Management as two of the few money management firms that had the resources as well as the will to design an effective system in-house. For most big firms, it isn't worth the time and money to design an in-house system, he added.
Which firms are keeping up with the regulators? Potasiak said today that a "tiny percentage" of the buyside will be able to meet the new standards.
Vendors Under Fire
But some wonder if the vendors themselves have all the tools needed. The question comes from a trading executive who works with the buyside.
"They (the vendors) don't supply any cost benefit functionality," said Michael Keady, an advisory board member to the Mutual Fund Directors Forum, a Washington-based non-profit group that represents independent board directors. Keady, a former Plexus Group partner, runs Fiduciary Investing Practices. He said none of these vendors are providing a comparison of how each broker is spending each commission dollar.
"With unbundling this is a critical factor. Firms need software to know who they owe money to and why, and just what they are getting for their commission dollar," Keady said.
Who are the logical candidates to buy these systems? Tier-One firms, those with over $100 billion in assets, usually have their own in-house systems, according to the study. However, even some of these giant firms will be looking to outsource commission monitoring, the study notes.
Tier-Two firms, those with under $100 billion but more than $10 billion in assets, would be the most likely candidates for these systems, according to the study.
"The sweet spot for vendors is going to be the Tier-Two firms," Grossman said. "They usually don't have the budget to build these kind of systems."
