New York, NY – In recent months, countless articles have been written about the impact of CSAs and CCAs on the brokerage and research industry, with most writers (us included) assuming that the use of CCAs would cause middle tier brokers and investment banks to close down their trading desks as execution was consolidated in the hands of fewer large brokers. And while we agree that this is a likely outcome, we suspect that the consequence of such a trend is much more chilling than most analysts would conclude. The following blog discusses some of these risks.
A number of developments, both here in the United States and in the United Kingdom have created the backdrop for today’s market environment. Of course, the move by the FSA to mandate that money managers disclose to pension funds how much of their commission dollars was being spent on execution and research was the first major step towards the current market environment.
UK brokers and money managers quickly decided that they needed a vehicle that would enable money managers to “unbundle” their trading decision from their research decision. Consequently, Commission Sharing Agreements were popularized as the structure of choice where money managers could trade with whoever they liked, and then they could direct a portion of the commissions they generated with these executing (CSA) brokers to pay for the research of third party brokers and independent research providers.
In July 2006, the SEC came out with its own interpretive guidance on money managers’ use of client commissions to pay for brokerage and research services under the 28(e) “soft dollar” safe harbor of the Securities Exchange Act of 1934. In this guidance, the SEC not only clarified its stance on what could be qualify for this “soft dollar safe harbor”, but the Commission also accepted the use of CSA type arrangements to pay for research services.
Subsequent to the SEC’s July 2006 guidance on soft dollars, the Division of Market Regulation issued a “no action” letter on January 17, 2007 to Goldman, Sachs & Co which confirmed that research firms who are not broker-dealers may be compensated for providing research services to their money manager clients through payments from a “commission pool” set apart in a client commission arrangement under section 28(e) without registering as broker-dealers. The payment structure described in the no-action letter — called a Client Commission Arrangement or CCA — is very similar in structure to a UK CSA.
In the wake of these developments, a large number of US bulge bracket firms have been aggressively marketing CSAs and CCAs to their buy-side clients, explaining that these new structures were considered “best practices” and they give clients the freedom to trade with whomever they think gives them “best execution” while still being able to pay anyone they think provides them with high quality research.
Consequently, over the past year or so, many buy-side firms have been consolidating their execution with fewer trading counterparties and they have implemented CSAs and CCAs in order to use these commissions to pay for external research providers.
The Consensus View
Of course, most market participants believe this development will be good for bulge bracket investment banks as they convince buy-side clients to use them as CSA brokers, thereby enabling them to consolidate execution. In addition, most assume the adoption of CSAs and CCAs will be bearish for second and third tier brokers as clients decide to use them primarily as research providers and not execution providers.
The consensus view is that many of these firms will be forced to become boutique research providers by closing down their trading desks. Of course, the firms that cannot make this transition are expected either to merge with other larger firms to gain economies of scale, or to shut down their operations altogether.
Alternative (independent) research firms are expected to win during this process as many buy-side firms look to replace some of the more expensive fundamental company research they receive from second tier providers with more innovative and cost effective research provided by small alternative research providers.
Impact on the 3 Pronged Business
However, it is clear that most second and third-tier investment banks can not accept being relegated to merely a “research boutique”. The primary reason for this is based on the inter-relationship of the three parts of their business — research, trading, and investment banking.
It is widely known that investment banking clients expect their bankers will also provide research coverage of their company and they will distribute this research to potential investors in their company’s shares.
However, market participants also explain that investment banking clients expect their bankers to support their IPO by making a market in their stock. This necessitates having a sales and trading operation to facilitate trading in their shares.
This means that it becomes quite difficult for second and third-tier investment banks to compete for banking mandates without a research capability or a trading desk.
Thus, the loss of trading business resulting from CSAs creates a real problem for these investment banks. They cannot really afford to keep their trading desks running, but they also cannot afford to close them down either without risking a good portion of their banking business.
Of course, losing their investment banking business typically means these firms cannot afford to hire the research analysts necessary to produce high quality research, a development that is negative for buy-side investors, particularly in sectors where research is less prevalent like the small cap market.
Not only does this impact the buy-side, but the loss of research and investment banking capabilities would have a negative impact on micro and small cap companies that rely on these second and third tier investment banks to help them raise capital and get research coverage.
As you can see, the impact of CSAs and CCAs could be much more widespread than merely prompting second and third tier investment banks to close down their trading desks. Losing their trading operations could threaten their entire businesses. In fact, this is one reason a number of second and third-tier banks have recently been investing in their trading platforms, including low touch electronic trading platforms, algorithmic trading, and DMA capabilities.
The following article recently published by Traders Magazine discusses the various issues many of these second and third-tier brokers are facing in dealing with the growing populartization of CSAs and CCAs.
Surviving the CCA Storm
October 25, 2007 – In June, Thomas Weisel Partners, a midsize investment bank based in San Francisco, purchased software from vendor FlexTrade Systems that allows its portfolio trading desk to better manage the timing of its trades. Last month, Weisel signed a deal with Townsend Analytics to distribute its algorithms through Townsend’s RealTick trading platform. In both cases the news is unremarkable, but what is significant is that a year ago, Thomas Weisel didn’t even have an electronic trading group. That the bank, best known for underwriting and researching small-cap growth stocks, is now plunging head first into low-touch trading speaks to its determination to remain a trading force in a world where order flow is slowly moving away from small and mid-tier broker-dealers.
The buyside’s use of client commission arrangements (CCAs) is eating into the order flow previously sent to boutique and regional houses. Set up by large trading houses, the arrangements allow money managers to consolidate their trading into fewer (and larger) hands. The buyside can now obtain research from the Weisels of the industry but direct their trades to the Morgan Stanleys. And buysiders are increasingly asking their smaller research providers to accept payment in hard dollars rather than order flow.
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