New York – Commission sharing arrangements (also referred to as commission sharing agreements) continue to make the news, with the latest being a cover story in the current issue of Traders Magazine. By my count we’ve posted six stories on CSAs over the last month. So what can yet another article on CSAs tell you, a loyal reader of this blog (oops, sorry, ResearchWatch)?
Much of it you already know: CSAs have been around for years but took off in the UK at the beginning of last year when the FSA required greater transparency for equity commission payments. Greenwich Associates is estimating that over half of UK commissions are now flowing through CSAs, and the portion is expected to grow. Michael Bird of Merrill is quoted as saying that about 80 percent of Merrill’s buyside clients in the U.K. had signed CSAs.
CSAs became popular in the US beginning last summer after the SEC clarified that CSAs qualify under the 28(e) safe harbor. The primary appeal of CSAs to the buy side is that they allow buy side trading desks to consolidate their counterparties from hundreds to 20 or less. The bulge firms are promoting CSAs aggressively to increase their trade flow at the expense of medium and smaller firms. Smaller counterparties will lose the trading portion of their commission allocations, but continue to receive an allocation for their research. One outcome will be consolidation in the number of trading desks at research boutiques and 3rd tier investment banks.
The article gets interesting when it considers whether CSAs are better for large or small investment managers. William Edick, an attorney who works with soft dollar brokers, argues that CSAs help small investors who often can’t get their phone calls answered today because their 200,000 share orders “mean nothing to the big brokerages.” By consolidating their commissions, they have a better chance of achieving the “preferred client” threshold with the bulge firms.
Some large investors express indifference. An unnamed fund executive asserts that CSAs don’t add much value to firms that generate high commissions volume. Matt Lyons, senior vice president, equity trading, Capital Research & Management, is quoted: “We don’t use them and I don’t suspect that we will.” Lyons would rather spread his orders around to avoid giving a single broker the mass of information implicit in a single large order.
Nevertheless, the evidence is that investment managers of all sizes are using CSAs to consolidate the number of counterparties. Mel Stimpson, head of global equity trading at Standard Life Investments in Edinburgh, notes that 90 percent of the firm’s flow is going through 14 designated brokers. Ian Firth, head of dealing at Morley Fund Management in London, says ideally he would have CSAs with every broker with which his desk trades. Morrow, with Capital Investment Services, is quoted as saying CSAs are inevitable: “I think when you’re looking out over five or ten years, this is the way the industry will be structured.”
Because the magazine is trader oriented, the article focuses predominantly on the implications for trading. CSAs are being promoted for their trading benefits, namely, improved execution and a reduced number of counterparties. There will be a consolidation in the number of trading desks for research boutiques and boutique investment banks.
The implications for research are more subtle. CSAs create a more defined cost for research, even for bulge firms. As CSAs become more prevalent, there will be greater scrutiny of those costs. For investment managers, the issue becomes how do I get the best possible research for what is now a finite research spend? For sell side research, there is a more defined revenue stream to manage research costs against. Increasingly, research will be viewed as distinct from the other services the bulge firms provide and evaluated more explicitly against alternative sources of research. In other words, consolidation will also occur on the research side of the equation, and it is not assured that the bulge firms will be the winners on that side.
Comment by Bill George:
“Wall Street Learns To Share”
I visited Traders Magazine On-line and carefully re-read the article titled, “Wall Street Learns to Share” by Jeremy Bresiger, Peter Chapman & Hillary Jackson which was published on January 3, 2007. (1)
Most of the comments in the article came from representatives of major full-service brokerage firms which because of their assumed order execution superiority appear to be the likely beneficiaries of Commission Sharing Arrangements (CSA’s), or from buy-side traders at very large investment advisory complexes which also seem to benefit from the use of client’s brokerage commissions in bundled undisclosed brokerage arrangements.
I’m arriving at the conclusion that the content of the article is clearly, and severely, skewed by the obvious bias of most of the quoted commenters, and also perhaps, by the editorial allegiances of the publication (Trader’s Magazine). The comments in this article with regard to the effects of CSA’s on unbundling and disclosure – in U.S. commission sharing arrangements – do not seem to apply to the way U.S. CSA’s are evolving.
Because no standards for disclosure or unbundling have been mandated for proprietary services in the U.S., it seems third-party research will continue to be fully disclosed and identified the way it has been [under Section 28(e)] for years. But, without a mandate for constructive disclosure in the bundled brokerage services arrangements of full-service brokers, it seems the identification, and separation, of proprietary research from other proprietary “services” provided by full-service brokers will continue to be as opaque as it has been throughout history.
The questions should be: Without constructive disclosure how does one distinguish between those proprietary services which qualify for the safe harbor of Section 28(e) and the other proprietary services that investment advisors purchase with client’s brokerage commission dollars? Further, without disclosure, how can one know, or qualify, that fiduciaries are using client’s commissions appropriately within their investment discretion, and for the “direct benefit” of their clients?
Can regulators and clients trust large full-service brokers and investment advisory complexes to use institutional client’s commissions for the direct benefit of those clients if disclosure of bundled commission arrangements is not mandated? Can research providers trust large full-service brokers to keep information secure (no front-running) and trust them to allocate commissions equitably? In my mind, the investigations and prosecutions of large full-service brokerage firms and investment advisory complexes since year 2000 make the wisdom of such trust questionable.