To Bundle or Not to Bundle? A Review of Soft Commissions and Research Unbundling (Summary)

Brokerage houses have historically bundled order execution services with research in exchange for higher execution commissions, which are known as “soft commissions.” This practice is controversial because research bundling can reduce transparency in pricing for different services and could lead to conflicts of interest between investment managers and end investors. In recent years, regulators have taken a more active role in this debate. Most notably, the European Markets in Financial Instruments Directive (MiFID II), which came into force in 2018, made the unbundling of execution and research services mandatory for firms that serve European customers.

One purported advantage of research bundling, however, is that it enables brokerage houses to cross-subsidize research services for small and medium-sized enterprises (SMEs). Prohibiting this could curtail research on and analyst coverage of smaller firms and potentially reduce SME financing opportunities.

This study provides a systematic review of the literature on soft commissions over the past few decades, focusing particularly on the effects from research unbundling under MiFID II.

The authors identify a list of keywords based on terms used in recent regulatory discussions and publications concerning soft commissions. They screen five major research databases with an economic focus for these keywords, searching the titles, abstracts, and text bodies of peer-reviewed publications. Their final publication set encompasses 59 studies. Most were published after the year 2000, with an uptick from 2015 onward in response to the MiFID II rules. Thirty of the articles used a qualitative approach, while 25 were empirical analyses.

The authors then screen these papers by their primary focus and establish seven categories, each of which addresses a certain aspect of the soft-commission discussion. They group the research articles into the following categories (with the number of studies in each category in parentheses):

1. Definitions (5)
2. General Legal Discussion (12)
3. General Economic Discussion (14)
4. Adviser Quality and Agency Conflicts (10)
5. Trading Costs and Commissions (8)
6. Fund Performance (6)
7. Research Unbundling MiFID II (4)

The authors aggregate and compare the results from the research studies and conduct meta-analyses where applicable. For the category pertaining to research unbundling under MiFID II, they group the four studies into multiple subcategories, such as the impact of unbundling on overall research coverage, coverage of SMEs specifically, and quality of research.

The bulk of the studies the authors look at conclude that soft commissions negatively affect investor welfare.

Most of the articles that focused on trading costs and commissions showed that research bundling leads to higher trading costs and commissions rates and that these are passed on to investors in nontransparent ways. For example, one 2016 paper found that expense ratios of funds and total commissions are positively correlated, implying that soft-commission arrangements are likely to inflate commissions paid per net assets. A 2021 paper emphasized that soft commissions enable management fees to be underreported.

Four papers provided empirical evidence of lower fund performance as a result of soft commissions, versus two that found evidence of better performance. The majority view was that research obtained with soft commissions adds less value than the costs created by premium commissions.

These effects were largely attributed to conflicts of interest between investors and investment managers as a result of research bundling. The literature primarily found that agency conflicts lead to a reduction in the quality of client services. In addition, many articles noted that a lack of transparent pricing of research and execution services impaired competition between brokers, again resulting in poorer investor outcomes.

In contrast, some articles in the publication set suggested that research bundling does not necessarily need to be banned. Because preferences between market participants differ, they argued that allowing the buy side a choice between bundled and unbundled prices for research optimizes welfare. However, these papers were based mainly on theoretical models rather than empirical studies.

All four papers that focused on the soft commission ban under MiFID II found that it resulted in decreased coverage of EU firms, by between 6% and 10%. In addition, they all noted an increase in research quality alongside a decrease in quantity. However, they also produced some contradictory results. For example, one study found that SMEs were more affected by this reduction in coverage than larger firms, but two others, contrary to expectations, found that losses of coverage were more concentrated in bigger companies. The authors note that these discrepancies might be explained by inconsistent definitions of SMEs among studies.

The authors state that further studies on this subject should examine the large shift over recent years toward passive investment strategies, in which research is typically less relevant than for active management. In addition, they call for further investigations into whether SMEs require special treatment to protect them from reduced coverage resulting from unbundling, as well as whether diverging rules between jurisdictions harms cross-border business between financial institutions.