New York-A recent survey in Traders Magazine suggests that client commission arrangements (CCAs) are spreading much more quickly and broadly in the U.S. than previously indicated. According to the survey conducted in April, 43% of buy side firms responding to the survey are using CCAs now and another 12% are planning to begin using them in 2007. Although it was not a statistically rigorous study, the survey does suggest that the penetration of CCAs in the U.S. is higher than we had previously thought.
The survey was conducted last month by sending an anonymous questionnaire to over 1,500 buy side traders. There were 100 responses representing a 6% response rate. The small sample size suggests we should treat the survey as indicative rather than definitive. Nevertheless, there are some very interesting nuggets.
The headline on the survey is the extent of CCA penetration in the U.S. It is very surprising that the majority of the respondents-55%–said they were either using or planning to use CCAs in 2007. There could be some self-selection bias here-those traders who are currently using or planning to use CCAs might be more motivated to fill out the survey than those who aren’t, which would inflate the penetration numbers.
Asset managers in the $50 to 100 billion range appear to be embracing CCAs most aggressively. Overall, the larger buy side firms seem to be most likely to use CCAs at this point. This finding is consistent with the adoption of CSAs in the UK. UBS says that 80% of its top UK clients use CSAs.
The main appeal of CCAs is to consolidate trading counterparties. In the Traders Magazine survey, the majority of CCA users have decreased the number of counterparties, and nearly half of CCA users have dropped their trading relationships to fewer than 30 counterparties. 78% of the survey respondents using CCAs expect there to be more consolidation. Those not using CCAs also expect consolidation-62% of those not using CCAs expect fewer counterparties.
Small and mid-tier brokers are feeling the pinch (see our article on CE Unterberg earlier this week.) There is no question that the impact of CCAs, along with the continuing technology and infrastructure investments required to maintain best execution, will squeeze out the weaker trading counterparties. This is one of the main arguments made against CCAs-it consolidates trading into a smaller set of firms, primarily the bulge firms.
Interestingly, less than a third (29%) of the survey respondents are concerned or very concerned about concentrating a greater amount of flow among a fewer number of brokers. This may reflect the competitive landscape. Although the bulge firms have been the most aggressive in promoting CCAs, buy side firms also execute CCAs through agency brokers like Knight, Instinet or CAPIS. Although outside the realm of CCAs, the execution only and dark pool providers also represent a major check and balance to the bulge firms for buy side traders. Our experience in the UK is that the larger buy side firms typically use 10 to 20 CCA brokers.
The implications for research are huge. The proliferation of CCAs accelerates the de-facto unbundling of research and execution. Although bulge firms have worked hard to structure CCAs so that their own research is exempted from the unbundling, we doubt this will endure. Firms like Marsico Funds are already using CCAs to unbundle both bulge and non-bulge research. Buy side firms will implement more coherent research procurement processes, and demand more accountability from research providers of all varieties. The era of “free” research is ending, and all research professionals-whether sell side, buy side or alternative-better be prepared.
The full Traders Magazine article.
Comment by: Bill George
As your article mentions because of the very high non-response rate in the Trader’s Magazine CCA study the results should be considered indicative rather than definitive.
I also believe it’s misleading to compare the implementation rates for CCA’s in the U.S. to the CCA implementation rates in the United Kingdom. The regulatory body in the United Kingdom (the Financial Services Authority) now requires fiduciaries to provide institutional clients with detailed disclosure of brokerage services provided in exchange for client commissions. Until similar disclosure is mandated in the U.S., U.S. Client Commission Arrangements may provide “cover” for conflicted interests, the abuse of institutional client commissions and fraud.
Other Concerns about Client Commission Arrangements:
The current structure of U.S. Client Commission Arrangements threatens several aspects of the current environment for third-party brokerage, independent research, and the use of institutional clients’ brokerage commission dollars.
(1) There seems to be a general opinion that bulge bracket, or full service brokers uniquely provide best execution. I don’t believe this generalization is supported by trading cost studies.(1) The assumption that bulge bracket and full service brokers (uniquely) provide best execution implies that as commission sharing arrangements evolve, advisors seeking best execution will focus their order flow on a small number of very large (and powerful) broker /dealers.
(2) Historically, independently produced research has competed with bulge bracket, and full-service brokers’ research. Independent research has provided independent opinions on investments when analysts at bulge bracket and full-service (investment banking) brokerage firms have become over zealous or when they produced research influenced by conflicting interests. Allowing bulge bracket full- service firms to be at the nexus of the receipt and allocation of research commission expenditures puts them in a position of controlling the revenue stream of their competitors; it might be compared to letting the fox into the hen house.
(3) Bulge bracket and full-service brokerage firms have resisted all attempts to require disclosure, transparency and the pricing of the proprietary services they provide. Without disclosure, transparency and pricing of proprietary services, third party research will be competing for its share of the commission allocation against an unknown abstraction (bundled proprietary services). There is no reason to believe the bulge bracket and full-service brokerage firms will fairly compensate sources of independent research that might frustrate their optimistic analysis, sometimes conflicted research, and lucrative marketing efforts.
(4) Investment advisors go to great lengths to prevent “leakage” of investment strategies, information sources, and research ideas. Holding such information confidential allows them to work their investment strategies and take advantage of their research discoveries. In the anticipated environment, with commission sharing arrangements consolidating order flow, the reduction in the number of trading venues and the concentration of the research payment process will give large brokerage firms special insight into trading strategies and research resources of investment advisors. It will also give a few large brokerage firms special insight into the pricing / cost of third party research. By observing commission payment information and trading information these few large brokerage firms will discover very rapidly “the what and when” about research effectiveness.(3)
(5) Under the recently released SEC “No Action Letter” (requested by Goldman Sachs)(2) it appears that research providers need not be registered, or meet any other specific qualifications or requirements to act as research “providers”. Payments will be made at the request of investment advisors and brokers will bear no liability. In the past, third party brokers have provided marketing assistance to research providers and have offered valuable insights (to research providers and to advisors) into regulatory issues surrounding research provision under Section 28(e) and ERISA. Allowing unregistered individuals to receive payments for “research” will introduce a host of unintended consequences, generate more opportunities for conflicts of interests and fraud, and increase the costs of oversight and discovery.
Footnotes:
(1) EDHEC Transaction Cost Survey / Study
(2) No Action request and response letters
(3) Concerns about special insights into competitors’ business Lisa Shallet, CEO of Sanford Bernstein