Woodbine Associates, a capital markets consulting firm, released a new report claiming that US$7.5 billion of U.S. equities commission spending is discretionary. This flies in the face of perceived wisdom that the majority of commissions are locked up to pay for research. Woodbine’s findings argue that buy side traders feel less obligated to investment banks than Wall Street assumes. Woodbine also expects that commission spending will flatten out over the next few years.
Woodbine’s new report, “Broker Opportunity Among Institutional Investors in the US Equity Market”, is based on an online survey of 49 senior traders at long-only asset management firms. Woodbine said the survey sample represents approximately 20% of the $10 billion long-only U.S. equity commission wallet.
Majority of commissions are discretionary
Woodbine’s survey indicates that 75% of the estimated US$10 billion long-only commission budget is discretionary and that 62% of institutional investors with more than US$10 billion equity AUM indicate that 90% or more of order flow is discretionary. ‘Discretionary’ means that traders believe they can send the commissions to any best execution broker they choose.
These results are counter-intuitive because other surveys have shown that as commissions have been shrinking since 2009, an increasing amount — 60% or more — of the commission pool is being allocated to pay for research. If more than half of the commission pool is needed to pay for research, how can 75% or 90% be discretionary? One potential answer: commission sharing agreements (CSAs).
CSAs = Discretionary?
There are two problems with the CSA solution to this puzzle, however. The first is that in the U.S. bulge bracket investment banks do not accept payment for their proprietary research through CSAs, requiring direct allocations for their research. In an interview Matthew Samelson, Woodbine’s CEO, indicated that the bulge banks had not relaxed this requirement. This would mean that Woodbine’s survey is saying that only 25% of US long only commission allocations are going to pay for bank proprietary research. We strongly doubt bank share has dropped that far.
The second problem with CSAs as the source of massive discretionary order flow is that CSAs represent only 35-40% of US equity commission volume.
Stabilizing commission budgets
Woodbine’s survey also projects a 2% increase in commission spending for long-only asset managers in 2015. Woodbine expects commissions to remain flat through 2016.
“It is too early to tell if this increase marks a sustained reversal in the downward trend,” Samelson said. “Our data suggests we are entering period of stabilized industry budgets.” He added that commission spending will continue to be a zero sum game. Growth will only come from taking market share from others.
We recently spoke with the head of commission management for a major long-only asset manager who said that his portfolio managers increasingly rely on boutique research firms for their stock analysis because of deeper sector or geographic expertise. In his view, the main value received from bulge firms is corporate access.
If this individual’s view is shared among other long-only managers, this would support Woodbine’s view that commissions are more discretionary than many sell-siders think. However, we struggle to see how 90% or even 75% of commission allocations are discretionary.
Traders rightly have a perspective that they can trade anywhere, directing any given trade to whomever they feel is the best counter-party. If I were to ask a bunch of senior traders what % of trades they can direct anywhere, I would probably get responses in the range of 75-90%. However, if I were to ask senior traders what % of their total commission spending must be committed to pay for research and advisory services, I would get very different numbers.
As for the outlook for commissions, flattening is a plausible scenario. The problem is that the buy side always overstates their projected commission spending. The Woodbine survey’s 2% growth in 2015 could easily be 5-10% declines. The reality is that commission spending is very hard to project accurately. Unfortunately the longer term pressures on commissions remain: shifts in assets from active to passive, regulatory measures to unbundle commissions, declining commission costs and the rise of electronic trading. Woodbine is correct in saying that growth will continue to be a zero sum game.
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Woodbine Associates, a market consultancy, reported commission spending contraction has stopped. While it has been on the decline since 2009, 2015 looks to have brought some good news. The firm projects a 2% increase in 2015 – but essentially spend should remain more or less “flat” to 2014 levels at least until 2017.”It is too early to tell if this increase marks a sustained reversal in the downward trend,” Matthew Samelson, chief executive officer and and director of equities told Traders. “Our data and analysis suggests — at minimum — we are entering period of stabilized industry budgets.”