New York, NY – As most readers know, Integrity Research Associates has written numerous articles on the positives and negatives of Commission Sharing Agreements (CSAs) and their US cousins, Client Commission Arrangements (CCAs), in the past year.
However, a recent development warrants that we revisit this topic. Last week, Euro IRP, the European trade association of independent research providers, and their US counterpart, Investorside published and distributed a position paper on CSAs and CCAs. This document was shared with the FSA and it has since been distributed to over 150 of institutional investors in Europe and US. This paper is extremely interesting and insightful. We have included a brief synopsis of the main points of the paper below.
CSAs Theoretically Positive, but…
In this position paper, the members of EuroIRP and Investorside admit that CSAs are “theoretically a positive development for the industry, helping meet the objective of separating the purchasing decisions for execution and research”. However, both organizations also acknowledge that customers (and regulators) need to be aware of and tackle a number of issues which threaten to harm both independent research providers, as well as the money managers who adopt CSAs or CCAs.
These concerns fall into two categories – the first being administrative issues and the second being potentially “anti-competitive practices” which the writers believe the FSA and SEC must be on the lookout for. They explain, “independent research firms are in a position where their competitors, the executing broker (investment bank), controls the payment mechanism. Such a situation is open to abuse and requires monitoring.”
Advantages of CSAs
The paper attempts to provide a balanced assessment of CSAs by explaining what EroIRP and Investorside members believe are the advantages of CSAs for investors, money managers, and independent research firms. This includes:
- A more level playing field for research providers: The paper argues that separating the money manager’s purchase decision into a research and execution decision, the mandated disclosure of how much was being spent in these areas, and the resulting pricing of formerly bundled research, has given clients a better idea if “value-for-money is being achieved when purchasing research using client commissions than is possible in a bundled environment”.
- The Search for Best Execution is more straightforward: The writers also explain that CSAs enable clients to hire brokers for one thing alone, and that is “best execution” without worrying about being able to pay for research from broker or non broker research providers.
- Price and Service Competition will Result for Execution: This position paper also explains that another benefit of CSAs is that the discrete pricing of execution which results should eventually lead to lower execution costs and increased service levels than existed in a bundled world.
Disadvantages of CSAs
Of course, EuroIRP and Investorside argue that recent experience with CSAs in the UK have not been a bed of roses for independent research firms, nor have they been without cost for money managers. Some of these issues include:
- Cashflow Issues: The position paper explains that most independents have experienced significant instances of non-payment, under-payment, and delayed payments which have hurt boutique research providers as CSA brokers in the UK are not required to make “prompt payment”.
- Voting Anomalies Favor CSA Brokers: An interesting point brought out in the EuroIRP paper is that many money managers’ vote processes have not progressed in a way to address the different roles a CSA broker might play – execution provider, CSA broker, and research provider. Consequently, CSA brokers are often overpaid through the vote process. This is explained as follows:
“At many clients, voting structures have now evolved to take account of CSA arrangements, with the vote split into the two main segments of research/sales and execution. However many of these new structures are very beneficial to the global broker, as they do not account for the execution portion which may be subtracted from the commission earned by the independent research firm under the research vote. Nor is this execution portion then accounted for under the execution portion of the vote, which the global house has already earned. By way of illustration, if global house A receives 100 points for execution but none for research, and independent B receives 100 points for research, under a 50:50 arrangement the global house will get 150 points of commission and the independent just 50.”
- Pricing and Contractual Terms: In most instances, a research provider has little or no contractual relationship with the execution provider. As a result, they have little leverage or recourse to insure complete and timely payment. In addition, in a “pooled CSA structure” the IRP has no knowledge or say in the commercial terms, including the research / execution split between the broker and money manager. However, in many CSAs this has a significant impact on how much the independent research firm is paid for their research.
For example, many CSA agreements today include a 50:50 research/execution split. Unfortunately, these are much worse than previous arrangements that many research providers were able to negotiate which were closer to 70:30. As a result, the global executing broker received a huge increase in the price it receives for execution versus the research product, while research providers are being paid significantly less under CSAs as they did in past payment sharing arrangements with brokers.
- Concentration in Execution Market: As we have mentioned in the past, the popularization of CSAs has led, in many cases, to increased consolidation of executing broker lists. One negative of this has been that some buy-side firms are struggling to generate sufficient commissions across all the markets and sectors in which they need to buy research. This means that these firms either have to cross-subsidize their research purchases, or the commission pools in certain sectors (small caps, for example) are insufficient to meet these fund manager’s research needs.
- Pre-funding of “proprietary” research: In some instances, the CSA broker is able to negotiate to take the first bite of the apple to be compensated for their research. This means all other brokers or independent research providers have to split up the remainder of the research commission pool. The writers of the position paper argue that this “distorts the spirit of the regulatory changes to level the research playing field.”
- Asymmetric pricing knowledge on research: Another point we have made in the past is that CSA brokers have an informational advantage over their money management clients regarding research pricing. A money manager only knows what it paid the broker last year for their research, whereas a CSA broker knows what different clients paid for their research. In addition, a CSA broker that also provides research knows how much a client is paying to other brokers and independent providers for their research services, putting them at a competitive advantage.
As a result of these various issues, EuroIRP and Investorside recommends that the industry develop best practices surrounding CSAs, and that the regulators (the FSA and SEC) endorse this process. These “best practices” should include:
- Payment for research must be made “promptly”, as mandated by the SEC.
- Equal treatment of “proprietary” and third party research by the CSA broker is critical. As a result, CSA brokers should not be able to get paid “first” for their own research.
- No deductions should be made from the research component for execution.
- Transparency on agreements should be promoted to avoid onerous terms, especially on pricing, being imposed by CSA brokers on IRPs.
- Money managers should work to reduce unnecessary payment delays due to their evaluation and reconciliation process, recognizing the damage this causes independent research firms.
- Money managers should maintain at least one CSA relationship with a pure execution provider, which serves as a check on global broker execution pricing.
- Money managers should ensure sufficient diversity in their CSA providers, encouraging competition and ensuring they generate appropriate commissions across all the markets and sectors in which they need to buy research.
- Money managers should make sure they are not signing CSAs which automatically pays the CSA broker the first portion (e.g. 20%) for research or specifying that its research department is paid first.
It is important to disclose that Integrity Research Associates (the publisher of this blog) is a member of Investorside and that Michael Mayhew (the author of this article, and the Chairman and Co-CEO of Integrity) is also a board member of Investorside.
A link to the complete EuroIRP / Investorside position paper on CSAs and CCAs is here: