There was no fanfare to announce the birth of commission recapture story in the US. It goes back to 1986, to two almost platitudinous observations: A Department of Labor pensions bulletin which commented that broker commissions are an asset of the pension plan and that the administrator of the plan had a fiduciary responsibility to conserves assets.
But these unremarkable views were enough to spawn a new business.
No one would raise an eyebrow at either statement, says Todd Burns, president of New York-based Lynch, Jones & Ryan (LJR) which offers commission recapture services. “The key thing was that it was the first time the department said it!”
The upshot was that the brokers focused attention on the capital owners rather than just on the investment managers to see what services they could provide. “We went to the pension plans and said if you have your managers trade with us, we will pass some of the commissions involved back.”
“How can we afford to do this? Well, we are specialists, which means we can do it cheaper than anyone else.”
Back in those days, commission structures paid for both the execution and ‘soft dollars’, where research and other services, including computers and quotation systems for asset managers were paid for by brokers out of commission.
LJR describes itself as ‘pioneers of the market’. “We like to believe we were first,” Burns says, as the firm’s earliest commission recapture clients date to 1986.
At first, the service was restricted to domestic equity trades, but later expanded to fixed income and to international trading both equity and bonds.
In 2002, the over-the-counter markets (OTC) underwent a change and started charging commissions as spreads disappeared from the business. Then LJR offered recapture services for OTC transactions as well.
The proposition is quite simple in Burns’ view: “If you are not engaging in recapture programmes, you are subsidising those investors who are.”
There are no official figures for the business, but you can do rough back-of-the-envelope calculations. “It could work out that the industry is giving back a quarter of 50% of the trades.” From LJR’s perspective over $500m (e375m) has been given back to clients in total by the firm since 1986.
“So if you include our competitors, the sums we have saved US pension plans over the years is pretty large,” says Burns.
One reason for the slow adoption by pension plans he attributes to the fact that it was just smaller brokerage firms which were offering recapture. But a more fundamental problem was the attitude of investment managers. “In those days, the asset managers felt those commissions were theirs to use as they thought fit. As a group they were very resistant to receiving a letter from the pension plan saying ‘We want you to do a certain percent of our business through these listed brokers’.”
The question of pursuit of best execution of course comes up, but even when the recapture brokers could prove the same levels of executions, they still were not accepted according to Burns.
So the pension funds and the commission recapture brokers had to keep making their case. “Just because we could prove our case on paper did not meant the concept was accepted.”
The same resistance was met when the recapture first arrived in Europe and Burns expects that in the Asian markets similar barriers will be raised yet once again. “In Hong Kong, Singapore and Australia all the same issues come up again about best execution and so on.”
In all letters of appointment, asset managers have a let out from using the recapture brokers if they do not believe they will obtain best execution from the brokers, he points out. “The point is that in reality nothing changes for the investment manager.”
The crux is to show that the execution of the commission recapture broker is the same as for other brokers. “Once they are convinced of that and the broker delivers the same level of service, then you have come a long way in convincing them.”
As a number of the recapture brokers developed to the point where they were able to go international. “This was particularly the case with the higher commissions available in Europe, where a lot more money could come back per share deal.”
The business in the US developed on the back of the big public funds which were always under pressure to make money or cut costs, then the corporate defined benefit plans were tapped. More recently the Taft-Hartley pension plans have been tackled, as well as hospitals, foundations, endowments and insurance companies. “A significant number of DB plans still do not use recapture services, so there are opportunities to grow.”
Well over three quarters of the new business the firm is taking in currently are plans that are new to recapture, Burns points out. “So there’s lots of growth potential possible in the US.”
The US recapture industry is still waiting for the SEC to issue guidance on the soft dollar issue, he says.
In Europe, where the London office has been operating for the past nine years, the business really took off four years ago. Investment managers had a much stronger say in how pension plans operated five years ago, than they ever did in the US, he maintains. “But the attitude has changed a lot in the last five years.” Now on the current cost-conscious climate, pension funds are ready to consider every aspect.
Commission rates have fallen globally but LJR continues to expand by offering commission recapture services in Tokyo and later this year in Sydney. The firm now operates in 19 different markets. “We see tremendous potential in the business for us still.”