New York—Client commission arrangements (CCA’s) are growing quickly in the U.S. and Europe, where they are also known as commission sharing arrangements (CSA’s). CCA’s are a catalyst for change in both trading and research, and, as such, are stirring up controversy. At last week’s Securities Traders Association conference in Boca Raton, CCA’s were one of the main topics of discussion. The larger sell side firms embrace CCA’s, whereas regional brokerage firms’ views range from cautious to downright hostile. And the buy side traders, though not widely represented by the STA, are generally positive, with reservations.
What are CCA’s?
CCA’s are an updated version of soft dollars, reflecting the reality that all services received through bundled, full service commissions are soft dollars. As the SEC make clear in its July 2006 guidance, receiving proprietary sell-side research through full service commissions is a form of soft dollars. CCA’s include broker research which, unlike third party research, generally does not have an explicit price tag. CCA’s split commissions into two pieces—one portion going toward execution and one portion set aside to pay for research. Investors can use their broker vote process to allocate the pool of commissions to the research providers.
Why the controversy?
The main appeal of CCA’s to buy side traders is the ability to reduce the number of counterparties. Prior to CCA’s, buy side traders had a long list of brokers which were primarily used for research, but required trading for payment. With CCA’s, the buy side can trade with whom they prefer, and pay others through the research pool.
The controversy arises from the dynamics being unleashed by CCA’s. Large sell side firms were quick to promote CCA’s and have been one of the primary beneficiaries of the resulting consolidation in trading. Regional brokers are suffering because of the loss in execution revenues. In theory, they could reduce costs on the trading side, but in practice the trading desks support not only institutional equities but investment banking. Responses vary from consolidation (such as Weisel’s recent purchase of Westwind) to cost reduction and increased focus on research.
Where are the regulators?
CCA’s and CSA’s are the indirect results of regulation rather than explicit regulatory creations. CSA’s became popular after the FSA implemented a commission disclosure regime in the UK in 2006. Their US counterparts, CCA’s, have flourished partly as result of CSA’s popularity and partly as the result of the SEC’s July 2006 guidance on soft dollars. The SEC also issued a no-action letter earlier this year to Goldman Sachs, allowing non-brokers to be paid through CCA’s.
Another no-action letter is expected before year end to address an issue of concern to some brokers, which is whether taking payments from a CCA will require brokers to register as investment advisors under the 40 Act. Brokers are exempt so long as research is incidental to their business and they receive no special compensation for it. Goldman had requested the SEC to address this issue in a no-action letter, only to be rebuffed. According to a few sources, a letter addressing the concern is about to be issued, and there is speculation about which broker dealer is behind the new letter.
The big question in the US is whether the SEC will draft commission disclosure rules, as the UK’s FSA and other European regulators have done. In the last week, Andrew Donohue, Director of Division of Investment Management, and Robert Plaze, Associate Director of Investment Management, both promised draft rules by year end. While encouraging, the SEC promised commission disclosure guidelines by year end 2006, so the track record on keeping this particular promise has not been good.
In the spirit of the STA conference, which asked speakers to look forward, here are our predictions for CCA’s:
1. Bulge firms will be the primary winners in the CCA land grab. They were the first to embrace the CSA/CCA concept and been the primary evangelists. Integrity is quoted in Traders Magazine predicting that nearly half of the $2.9 billion in commissions going to smaller regional firms will go to the bulge firms. How did we get there? With two other predictions: 70% of US buy side will adopt CCAs over the next four years, equivalent to CSA penetration in the UK. Bulge firms will get two-thirds of CCA business, reflecting their first mover advantage.
2. Execution only providers will also benefit from CCA’s, despite being initially on the sidelines. They will be dragged onto the CCA dance floor by the buy side, who will want execution only CCA’s to balance out their CCA brokers. Related to this, the buy side will use multiple CCA brokers so that no CCA broker will have too much visibility into research spend.
3. There will be consolidation in the number of traditional sources of research. Fundamental research providers will be under pressure to differentiate their research as the buy side becomes more discriminating in spending its research pool generated by CCAs. There is already consolidation occurring among regional brokers and the bulge brokers will not be immune. Some bulge firms will shut down their proprietary research the next downturn in commissions.
!–44. Consolidation in traditional research will be more than offset by growth in non-traditional sources of research. We are seeing a proliferation in innovative, non-traditional sources of research. Examples include primary research like expert networks or search-based research, specialized research such as forensic research or ESG providers, market research firms, and industry specialist firms. Our database has expanded to include 1,500 research firms, and it is still growing quickly. We believe that CCA’s will support a profusion of non-traditional research firms, and the total will top 5,000 firms.