Speech by SEC Staff:
Keynote Address Before SIFMA's Institutional Brokerage Conference
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, New York
June 4, 2008
Good morning. It is a pleasure to be here and I would like to thank SIFMA for inviting me to speak with you today. Before I begin, I must of course note that my remarks today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
I am particularly excited to be speaking with you in the context of this conference — the "Evolving Marketplace". Although our markets are of course constantly evolving, as they say "nothing endures but change," it certainly seems that these changes are accelerating. The developments in our markets are truly and fundamentally transforming the way the securities industry operates. These changes are not anymore dramatic than in the institutional brokerage area. Indeed, my staff recounted a highly experienced trading professional expressing his amazement at this fact during a meeting at the Commission. This professional remarked that in all his 25 years working in this industry, he has never seen the rapid pace and extent of change in the way trading is conducted as he has seen over the past three years. I would imagine many of you who are this professional's contemporaries, including myself, feel the same way.
Not only am I excited to be speaking with you about marketplace evolution, I am excited to be doing it here in New York. The New York area is my home — I have lived here my whole life. The markets are, in a way, also my home — they have been the focus of my entire legal career and I, like all of us, have always tried to keep up with the latest market developments. However, in paying attention to new developments in the markets, one thing that I have noticed since my orientation switched from New York to Washington is that change and developments happen in different ways depending on your perspective at the time. Although Washington is only about two hundred fifty miles from here, in many ways it is a world away. One way that I see this difference is how change occurs. In Washington, change is often deliberate. For example, we change leaders in regularly occurring, planned election cycles — of course you can't escape this fact these days. Also policy changes occur only with an intentional action, even when they are occasionally long overdue. But here in New York, and in our markets in general, change occurs for any number of reasons and it is driven by a variety of forces. The clearest force for change recently, of course, has been technology. As you know, technology is driving the fundamental changes to how we conduct business in our financial markets and its tremendous impact on the institutional brokerage industry will be evident throughout the panel discussions today.
Although the forces underlying change are different in New York and Washington, our worlds are of course interconnected, particularly with respect to our markets. Today I would like to focus my remarks on how we are seeking to address the developments that are occurring in our financial markets and what our role is as a regulator in the context of the evolving marketplace.
II. Soft Dollars
The first topic I would like to discuss is one that I am certain is of great interest to many of you in the institutional brokerage area, and that is the use of brokerage commissions to purchase research and related services. In other words, the use of soft dollars. Securities research and the ways in which research is purchased is an area that truly encompasses the concept of the evolving marketplace and many of the issues you will discuss today. In fact, it seems that soft dollars will be covered in some regard in each of today's panel discussions.
Soft dollars of course play a significant role in how trading is conducted. Soft dollars affect how the industry structures its relationships and influences how trading decisions are made. In light of the significant impact of soft dollars on the brokerage industry, the Commission has devoted a correspondingly large amount of time to the serious issues raised by the use of soft dollars since they came into their current use following May 1, 1975, or May Day. On that day the Commission acted, followed later by an Act of Congress, to abolish fixed commission rates. Of course long before that when broker-dealers could not compete on the basis of commissions for executing orders, they became accustomed to competing for institutional order execution business by offering research reports and other services to investment advisers. With flexible commission rates, there was a concern that if investment advisers managing institutional accounts were to pay brokers more than the lowest commission rate available for a transaction, the advisers would be exposed to charges that they had breached their fiduciary duty to act only in their clients' best interests and not their own. The purchase of research with soft dollars, even if used for the benefit of the client, creates a conflict of interest for the adviser because the adviser is now relieved of the obligation to produce the research himself or to purchase it with his own money. Congress addressed this concern by providing a safe harbor for advisers that use soft dollars under certain conditions. This safe harbor, contained in section 28(e) of the Securities Exchange Act of 1934, provides that an investment adviser does not breach its fiduciary duties when it has paid brokerage commissions in excess of an amount another broker-dealer would have charged if the adviser determines in good faith that the amount of the commission is reasonable in relation to the value of the brokerage and research services received.
Since section 28(e) was enacted the Commission has issued several releases interpreting that section. It has also on a number of occasions indicated how the conflict of interest issues associated with soft dollars impacts an investment adviser's fiduciary obligations to its clients. In addition, the Commission has brought enforcement actions involving purported soft dollar practices and the Commission staff has published reports dealing with soft dollars.
The Commission's latest release in this area was issued in July 2006. This release provides interpretive guidance on which brokerage and research services broker-dealers may provide that would allow an investment adviser to remain eligible for the protections under the section 28(e) safe harbor. The release also clarified how advisers may use these eligible items and reminded that advisers must determine in good faith that the commissions paid are reasonable in light of the value of the research received.
B. Market Developments Since the 2006 Release
A particularly significant issue that the 2006 release also addressed was the availability of the safe harbor when research services are obtained through so-called client commission arrangements or commission sharing arrangements. As you know, in these arrangements an adviser agrees with an executing broker-dealer that a portion of the commissions paid will be credited to purchase research either from that broker or another research provider, as directed by the adviser. By addressing these types of arrangements, the Commission seems to have sparked a seemingly revolutionary development that was foreshadowed by an SEC Commissioner very shortly after May Day. Commissioner Philip Loomis, when reflecting on the state of the market in June 1975, observed that research is needed, that it comes from many independent sources, but that, in the current state of the market research must be paid for by commissions "since mechanisms and procedures for paying for it separately simply did not exist." Commissioner Loomis did follow this by noting his preference as an ultimate outcome to May Day would be for research to be marketed for a separate charge.
Well, it seems that Commissioner Loomis' time just might have arrived, or at least we are on its cusp. By interpreting section 28(e) in a manner that gives investment advisers flexibility in seeking access to brokerage and research services through a broader range of payment mechanisms, the Commission appears in the 2006 release to have encouraged the use of new types of client commission arrangements and commission sharing arrangements. As we similarly saw in the U.K., where the popularity of these types of arrangements grew significantly in response to the FSA's regulatory unbundling requirements, it is expected by some that by 2009, 25 percent of U.S. firms overall will pay for research in this way.
Developing hand in hand with the greater prevalence of different payment arrangements for research is the rapid increase in the use of alternative trading systems for executing securities transactions. Over the last few years, algorithmic trading, dark pools and other technology-driven methods of trade execution have quickly taken over a large part of the institutional brokerage landscape. There do not seem to be any signs of this phenomenon slowing down any time soon. The share of U.S. equity trade volume executed by algorithms, having grown from 28 percent in 2005 to 33 percent in 2006, is expected to exceed 50 percent by 2010. For dark pools, as of the third quarter of 2007, it was reported that they accounted for approximately 15 percent of all U.S. equities market share, and, by 2011, this number is expected to rise to 20 percent.
There are of course implications to the tremendous growth of alternative trading systems and the increasing dependence on the use of technology in the brokerage industry. One implication, as you would expect, is that the amount of expenditures on trading technology and services is quite substantial. One estimate I saw placed this cost globally at over $45 billion in 2007. Another effect of the use of these technologies is an overall reduction in the amount of gross commission rates. It will be interesting to see how these developments affect trading as a whole as our markets continue to evolve.
Other implications of the dramatic changes we are seeing appear to me to be very positive and are presenting market participants with some tremendous benefits. For example, client commission arrangements and commission sharing arrangements are allowing advisers to choose brokers solely on the basis of execution performance, while obtaining research from a number of other providers. Also the use of technology-driven trading mechanisms has led to an overall improvement in the efficiency of institutional trading. For example, algorithms help find the most efficient venues for executing different types of orders, and dark pools, particularly block crossing systems, allow buyers and sellers to find each other while avoiding costs that might arise from information leakage. In general, we are seeing lower transaction costs of large orders and, as I mentioned, commissions are overall becoming significantly lower.
C. Regulatory Challenges Posed by Recent Market Developments
Although the recent trading developments are in many ways positive, the developments also present a number of challenges. In February, at the SIFMA dark pools symposium, as some of you who attended may recall, the Commission's director of Trading and Markets, Erik Sirri, spoke of some of the regulatory concerns dark pools and other trading developments are presenting, such as those relating to transparency, fragmentation and fair access.
Erik also mentioned best execution challenges that market developments pose for broker-dealers. In doing so, Erik noted that "one of the challenges presented by an evolving market structure that is continually generating new venues and new services is that best execution policies and procedures must evolve as well." Today I would like to echo this view especially as it applies to investment advisers. An investment adviser has an obligation to seek best execution for its clients' securities transactions — that is, to seek the most favorable terms reasonably available under the circumstances, or those that represent the best qualitative execution for the account.
In this ever-changing environment, with the many options for trading venues available, the way investment advisers fulfill best execution obligations is more complicated and challenging than ever before. Also, in considering best execution, advisers should consider not only the commission, or spread costs of each trade, but also the implicit costs, such as price impact, information leakage and opportunity costs. To minimize these types of costs, advisers should have formulated and adopted policies and procedures designed to determine the appropriate trading venue for each transaction: Is the use of a dark pool appropriate with low commission costs and minimized market impact and information leakage? If so, should the adviser use multiple pools or more aggregated ones? Is algorithmic trading needed to find liquidity? Should research be purchased — if so which research and in what type of arrangement?
Although best execution is becoming increasingly complicated, advisers' trading decisions are critical for their clients as the amount of transaction costs, both explicit and implicit, incurred during a typical year can be substantial. For example, one study estimates that the average annual trading cost for a sample of 1706 U. S. equity funds during the period 1995-2005 was 144 basis points. While the average expense ratio for these funds during the period was 121 basis points.
D. Commission Guidance to Fund Directors
It is in light of the benefits and challenges of the evolving marketplace that my Division is developing a recommendation to the Commission as to how fund directors should oversee the trading practices of investment advisers to funds, including their use of soft dollars, to ensure that investor interests are being protected. On the one hand, we want to be certain that any regulatory action would not "freeze in time" the evolving market and disrupt the positive developments that are occurring. Also, in many cases, the market takes care of matters on its own and often in the most efficient manner. For example, I have seen predictions that with natural market consolidation the currently large number of possible execution venues in the equity markets could potentially evolve into only a few large players, which may simplify best execution obligations. Also, the increased use of electronic methods to order, track and analyze securities trading, has increased transparency of the costs associated with trade execution. This development is allowing advisers to determine, and fund boards to oversee, with greater certainty the expense of research funded by client assets and "virtually unbundle" research and execution services. Furthermore, the use of commission-sharing arrangements may enable a clearer determination of the actual amount of commission dollars used to pay for research and those used to pay for execution.
In light of these changes in the marketplace, the Division recognizes the need to provide additional guidance to assist mutual fund boards in their oversight responsibilities with respect to overseeing best execution and the use of soft dollars. In preparing recommendations for guidance, the Commission staff has met with industry representatives, including investment advisers, independent fund directors and directors' counsel. We are seeking to ensure that our guidance reflects actual market practices and is based on actual industry experience. Accordingly, we are taking into consideration the fact that regulatory guidance needs to be flexible enough to accommodate rapidly evolving market conditions and practices in the area of soft dollars. To this end, it may be more helpful for fund boards and compliance professionals to have guidance that provides a framework for them to work within when fulfilling their responsibilities, while maintaining flexibility for firms and fund directors to oversee trading operations in a manner they determine appropriate in light of their particular circumstances.
I would also like to note that although we are approaching our recommendation for guidance to fund directors with some flexibility given the current state of the market, the conflicts associated with trading decisions, and particularly soft dollars, are very serious. We were reminded of that with the recent enforcement action involving Fidelity. In that case, the SEC charged Fidelity Investments, a fund manager, and certain employees, for, among other things, failing to seek best execution by improperly accepting more than a million dollars in travel, entertainment, and other gifts from broker-dealers in order to obtain Fidelity's brokerage business.
As the Commission may consider the Division's recommendation for guidance to fund directors in this area, they will be doing so against the fascinating backdrop of the evolving marketplace. On the one hand, the fundamental conflicts of interest that have been associated with certain trading practices and the use of soft dollars ever since May Day, 1975, and even well before, still exist. However, they do so in the context of the fast-moving target that is the institutional brokerage industry today. Also, given the history of Commission action regarding best execution, soft dollars and other institutional brokerage issues, it will be interesting to watch how the capabilities of technology interplays with regulation over the years to come. This interplay will be particularly interesting with respect to the brokerage industry as it continues to develop and our markets evolve into a form we probably today can't even imagine.
III. Market Pressures and Affiliated Transactions
As a final topic, I would like to change direction a bit and briefly talk about our role when market events occur, not through such forces as technology or changes in regulatory requirements, but when market developments are adverse and unforeseen. We have seen these types of events recently, such as with the crisis in the subprime markets. More recently the markets experienced this type of event with respect to auction rate preferred securities.
When problems do occur in our markets, we often receive requests to relieve regulatory restrictions in order to allow market participants to respond in a way that our rules may not permit. Although there may be pressure to provide certain relief, when evaluating any requests, we will do so from the perspective of what is in the best interests of the fund and the fund's shareholders. In this regard, we recognize that in times of stress our regulatory requirements are more important than ever. For example, when faced with liquidity concerns, we are often asked to provide relief from restrictions against certain affiliated transactions contained in section 17 of the Investment Company Act. Section 17 was enacted in 1940 in response to serious abuses involving overreaching, self-dealing and securities dumping that occurred in the investment management industry in the 1920s and 1930s. To this day, section 17 restrictions continue to play a vital role in protecting investors' interests. For this reason, with regard to requests for relief from this section, and any other restrictions, we would seek to find alternative means of both achieving regulatory goals while not unnecessarily preventing market solutions to problems as they arise.
Again, I want to thank SIFMA for inviting me to speak with you today. The world of institutional brokerage is moving so fast, I wonder if holding a conference on the issues associated with the evolving marketplace just once a year is enough. It seems with each day, something new and exciting is happening in this area — it is a fascinating phenomenon to watch and to be a part of. Thank you.