The Tale of Shrinking CSA Pools and Trading Desks

New York, NY – In the past nine months, the team at Integrity Research has written numerous times about shrinking equity commissions and the impact this would have on both sell-side and alternative research providers.  We still hold to this view.  However, a number of alternative research providers have told us that despite the current market environment, they have been reconsidering whether they should set up their own trading desks, rather than relying on hard-dollar, soft-dollar or CSA payments.  We will try to analyze why this might be happening.

Bundled Providers Overpaid

Historically, buy-side analysts and portfolio managers have found it considerably easier to pay for the research they consume by having their trading desk direct trades that they need to execute anyway to the research providers’ trading desks versus having a check cut or a soft dollar payment made.

However, a growing number of alternative research providers have come to the realization in recent years that offering their research as part of a bundle is not only easier for the buy-side client, but in many instances this type of relationship enables them to get paid considerably more for their research than if they charge a subscription price that is paid either through hard dollars, soft dollars, or a CSA relationship.

In fact, cynical market participants argue that this is the very reason that most sell-side investment banks refuse to price their research on a hard-dollar basis.  Not because it is too difficult to come up with a specific price for their research, but because they would earn significantly less for their research on an unbundled basis than through a bundled arrangement.

If this is true, then alternative research providers that are paid through subscriptions have traditionally been underpaid versus research firms that are being paid through trading relationships.

Some Refuse to Establish CSAs

According to a study conducted by Integrity Research during the 4^th Quarter of 2008, approximately 64% of all buy-side participants had at least one CSA relationship.  This means that 36% of all buy-side firms did not have CSAs in place.  We also asked the group with no CSAs if they planned to be adding them in 2009.  A little more than half of the group surveyed said they did not plan to add CSAs.

This means that slightly less than 20% of all buy-side firms refuse to use CSAs.  Given the reasons that most of them gave for not using CSAs, we suspect a significant number of these buy-side firms also don’t use soft dollars to pay for third-party research.  Consequently, these firms either pay for research with trading commissions or via hard dollars.

Unfortunately, with some firms refusing to use CSAs, and other buy-side firms slashing their “hard dollar” budgets by large margins, many third-party research firms that get paid primarily through hard dollar subscriptions have seen their revenues plunge.  As you might guess, a few of these firms have begun actively wondering whether they should open trading desks to facilitate payments for their research.

CSA Pie Shrinks as Clients Increase Trading Partners

Another factor driving some firms to consider starting trading operations is the shrinking CSA payments that are falling even more sharply than overall equity commissions.  One reason that might explain this divergence is that equity commissions could be falling at many CSA brokers as buy-side clients do an increasing amount of execution business with regional and agency brokers.

In the past few years, we saw bulge bracket investment banks use CSAs as a means to convince their clients to consolidate their execution business with a smaller number of firms.  This benefited the large CSA brokers and hurt the regional and agency brokers.  Of course, this also helped third-party research firms that were paid with CSAs as these balances grew as investment banks consolidated execution balances at their firms.

However, in the wake of the Lehman Brothers failure, many buy-side firms decided it made sense to conduct more execution business with regional and agency brokerage firms that did not have large portfolios of subprime mortgages.  Many of these firms were seen as lower risk counterparties than the large bulge bracket investment banks.  Consequently, CSA balances at the large investment banks probably shrunk as a result of losing market share to regional and agency brokers. 

Of course, client redemptions, falling buy-side AUM, and less volatile equity markets have also caused sell-side equity commissions to fall in 2009.  In combination, these two trends have probably led a number of bulge bracket CSA brokers to experience sharp declines in their CSA balances – a trend that has had an extremely negative impact on alternative research firms that receive a large proportion of their revenues through CSA payments.   

This factor has also led some to consider starting trading desks to make it easier for clients to pay for their research services.

Other Reasons

A few independent research firms have considered opening trading desks for other reasons.  One reason that we have heard is from a few firms that are looking to add M&A advisory to their suite of services.  These firms need to be registered broker-dealers in order for them to be able to get paid as part of investment banking deal.

Summary

In 2006, the SEC came out with an interpretive guidance which led many in the financial services industry, ourselves included, to conclude that the number of independent research firms that supported trading desks would decline as buy-side customers moved to paying for their research through the use of CSAs.  However, in 2008 and 2009, market conditions changed so significantly, that a growing number of boutique research firms are reconsidering whether it makes business sense to open trading desks to enable buy-side clients to pay for their research versus charging a subscription and being paid with hard dollars, soft dollars, or Commission Sharing Agreements.