Counterparty Risk, CSAs and a Broker Consortium


New York, NY – Following last year’s shot gun wedding of Bear Stearns and JP Morgan, Lehman Brothers’ failure, Merrill’s tie up with Bank of America, and the severe weakness seen in numerous other well-known investment banks, many institutional money managers have become increasingly concerned over the counterparty risk associated with their prime brokers and CSA partners.

During the 4th Quarter of 2008, Integrity Research Associates interviewed 105 buy-side firms about these fears and other related issues in a detailed survey of buy-side usage of CSAs.  Some top line results of this survey will be discussed at this week’s New York AQ Research Conference called Master’s of Change.  This topic, and many others, is covered in Integrity’s comprehensive ResearchFocus report on Commission Sharing Arrangements and Client Commission Agreements, slated for release on Wednesday, January 14, 2009.  The following is an excerpt from this upcoming report.

Weaknesses of current CSA Offerings

Integrity polled buy-side investors about the major weaknesses they perceived with their existing CSA providers, and how they wished their providers would improve their offerings. Here were the major problems identified by the survey participants:

Counterparty Risk – This was by far the most common issue, identified by 81% of survey participants. The vast majority of clients see a serious problem with leaving large CSA balances at investment banks. Going forward, we expect that large asset managers are highly likely to aggressively manage the size of these balances.  The tendency of banks to drag their feet about making payments to research providers exacerbates the risk, as banks which remit payments only a few times a year may be carrying very sizeable CSA balances that are neither segregated nor insured in any way. The fate of these assets is highly uncertain in the case of a bankruptcy. This is a major area of concern for buy-side directors of trading and broker liaisons.

Lack of Breadth/Depth of Research Providers and Brokers on Platform – This was a frequently cited issue (33%) with some of the “CSA specialists” who offer platforms that third-party brokers and research providers must join in order to receive CSA payments. Although quite popular, there is a widespread perception that these platforms are lacking sufficient coverage of different global regions and / or sectors.  Many clients expressed a wish that the firms running these platforms would expand their coverage by adding more research sources.  This can particularly be an issue with platforms, like the one offered by BNY Westminster, that charge brokers to participate.

Poor Analytic Tools and Web Site Features – A substantial proportion of the clients surveyed (33%) expressed the opinion that current CSA platforms were lacking in features, usability, and analytic tools. Integrity Research goes into substantial detail in the soon to be published CSA ResearchFocus report regarding which particular features may be of highest value to the buy-side.

Poor Reconciliation – Many buy-side clients (28%) have faced problems with trade reconciliations, and almost all of the sell-side brokers rated in our report have received complaints about their reconciliation process.  The largest number of complaints is associated with major US investment banks that were perceived to be uncommitted to quickly resolving trade reconciliation issues, and were seen as being unresponsive to smaller client accounts in particular. Smoother reconciliation, whether achieved through technological means or by simply adding more customer service personnel, would be an extremely valuable improvement from the perspective of most buy-side clients.

Poor Customer Service – Another way CSA brokers could improve their offerings would be to improve their customer service, as 28% of those surveyed cited this as a weakness of existing CSA providers.  The most common source of this complaint were smaller hedge funds and money managers, who felt as if they were being treated like second-class citizens when it came to reconciliation, remittances, and other CSA services. The complaint was applied most often to large investment banks, and least often to agency and discount brokerages.   While it makes sense that the large brokers would expend most of their resources serving their largest clients, the relatively poor ratings smaller clients give bulge bracket firms on their customer service suggests that these firms are at least somewhat likely to shift their trading activity to discount and agency brokerages.  In aggregate, this could prompt a fairly substantial shift in trading volume towards these discount competitors and away from bulge-bracket brokers.

The fact that many discount and agency brokerages offer highly competitive and attractive CSA platforms means that money managers who shift trading activity to these providers may experience no substantial loss in terms of the quality of research they have access to. In short, it may be the case that the only substantial reason for smaller money managers to remain with some of the large investment banks is to continue to receive access to the in-house research produced by these investment banks. The generalized trend towards unbundling may make such a trade-to-receive-research model obsolete.  At that point the large investment banks will have to compete in terms of quality of execution, quality of service, and the actual attractiveness of their execution and CSA platforms. Given the incentives at play, we expect large investment banks to resist any significant efforts to make it possible for the buy-side to pay for their research in an unbundled manner, as this would cause them to lose a significant amount of market power.

Slow Payments – Another commonly raised issue (cited by 22% of respondents) had to do with the perception that CSA brokers were likely to sit on payments for months at a time, putting undue pressure on independent research providers. Again, the major US investment banks were seen as the primary culprits on this front.

One Answer – CSA Consolidation

Integrity Research also asked asset managers how best to resolve the various concerns voiced above.  One topic that is gathering considerable attention in the marketplace is the possibility of developing a consolidated CSA platform in an effort to reduce the administrative headaches of managing multiple CSAs and eliminate the counterparty risk of leaving large unpaid balances in CSAs managed by investment banks or brokers.  Integrity asked survey participants how valuable they thought such a platform might be to them.

Overall, survey participants felt that some sort of consolidated CSA / CCA management system would be useful as 68.5% of investors thought such a platform would either be somewhat or extremely valuable.  Close to 70% of investors who use their CSAs primarily for North American business expect that a consolidate CSA platform would be valuable, whereas 80% of buy-side participants who use their CSAs on a global or multi-regional basis thought a consolidated CSA platform would be valuable.  It is interesting to note that 40% of investors who use their CSAs on a global or multiregional basis thought such a consolidated CSA platform would be extremely valuable.

Who Best to Run an Aggregated CSA Platform?

Integrity also asked buy-side participants what type of firm or organization would be the best, in their opinion, to manage an aggregated CSA platform.  The various results are discussed in more detail below.

Large Investment Banks – Several of the large investment banks have attempted to market themselves as a “hub” or “central” platform for execution and commission sharing. However, fewer than 7% of the participants in our survey are interested in aggregating their entire CSA pool with a single large investment bank. There are numerous reasons for this.

As discussed previously, counterparty risk has become a major concern for the majority of the buy-side. This naturally rules out aggregating all trades with one single investment bank, as such a course of action presents practically no protection whatsoever against the counterparty risk of that bank.  Currently, money managers can mitigate counterparty risk concerns somewhat by spreading out their CSA pools and order flow to multiple institutions.

Another major reason why aggregation with a single investment bank is unlikely to take place has to do with the issue of trade confidentiality.  Large asset managers see far too much possibility for information leakage in aggregating all of their trading and research acquisition activity with a single investment bank. Firewalls have been known to be breached in the past. Even if specific trade info is relatively well protected, such consolidation would give a single investment bank a huge asymmetric advantage in knowing what clients are paying for research and execution services, which would be to the overall detriment of the buy-side. If nothing else, the need for competitive pricing of research and execution services rules out consolidation with a single bank.

Agency Brokers / ECNs – Many of the same concerns that rule out consolidation with a single investment bank also apply to the idea of consolidation with a single agency broker or ECN.  This option gained the support of 9.3% of our survey participants, slightly higher than the 7% garnered by the “large investment bank” option.  Although agency brokers and ECNs are often seen as neutral intermediaries, with fewer conflicts of interest than investment bank counterparties, consolidating all CSAs with a single agency broker or ECN still presents the possibility of counterparty risk and leakage of trade and pricing info.

Independent Firms – Several independent firms, including Cogent Consulting and Investars, offer products aimed at consolidating the management of CSAs. This type of consolidation often represents a sort of “virtual” consolidation, wherein CSA balances are still kept at the individual brokers that generated them, but all management, payment instructions, and reconciliation activity is centralized by a single provider.

This “centralized management and dispersed funds placement” model addresses the buy-side’s need for convenience, while enabling them to continue pursuing “best execution” with multiple trading partners, and mitigating some of the counterparty risk of having CSA funds located in just one place.  Also, independent firms with no trading activities of their own are seen as highly unlikely to breach confidentiality or possess conflicts of interest.

A disadvantage of this model is that it may add another layer of costs to the participating brokers.  In addition, those independent firms that would propose to hold custody over CSA funds may not have the scale or financial stability required to mitigate the counterparty risk issue for most buy-side money managers.  Furthermore, without buy-in and support from the large investment banks and brokers, independent firms may find it very difficult to offer smooth reconciliation and remittance processes.  Nevertheless, this was the most popular choice with survey participants, garnering 44.2% of the vote. It reflects a widespread desire that CSA pools be held by a neutral body with no conflicts of interest.

Broker Consortium – One idea that is still in the planning stages is the establishment of a Broker Consortium to manage a consolidated CSA / CCA platform.  This idea garnered support from nearly 40% of the buy-side firms we surveyed. A CSA pool backed by a consortium of brokers presents the advantages of convenience and flexibility while mitigating concerns regarding counterparty risk.  In theory, such a platform would allow the buy-side to trade with any of the brokers participating in the consortium, and have all those trades credited to a CSA pool that can then be managed in one convenient, centralized location. However, for such a consortium to be successful and widely adopted, it needs more than merely the backing of a few large brokers.

For more informationabout on how to purchase Integrity Research’s new ResearchFocus report on Commission Sharing Arrangements and Client Commission Agreements, or to subscribe to the annual ResearchFocus service, please contact Matthew Bannister at 646-786-6851 or e-mail him at


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