Why All The Trading Desks?


New York – Riddle me this: Why are alternative research firms adding trading desk capabilities while commission sharing arrangements, which allow investors to trade with one counterparty and pay for research from a different counterparty, continue to grow?  Answer: persistent misunderstanding of soft dollars on the part of pension funds and other asset manager clients.

Commission sharing arrangements (CSAs, also known as Client Commission Agreements or CCAs) have been growing for two main reasons.  Initially, they appealed to investors as a vehicle to reduce the number of trading counterparties.  More recently, they provide a mechanism to reduce commission expense by converting full service commissions (4-5 cents per trade) to cost-plus trading (typically half the cost of full service).

The paradox is that although usage of CSAs is growing, so is the popularity of trading desks for alternative research firms.  Firms such as IRC Securities offer the ability for research boutiques like Meredith Whitney Advisory Group and Zelman and Associates to offer investor clients direct trading execution.   When CSAs first began to be broadly adopted in 2006, the predictions were that trading desks would become less necessary and less widespread, but that doesn’t appear to be the case.

We have speculated in the past that the markups by CSA brokers may be an answer to this paradox.  Although CSAs/CCAs save money on full service commissions, they are still a more costly payment mechanism for investors than direct trading.

We recently met with an asset manager which provided another clue to the paradox.  The asset manager has about $1 billion in long/short and short only, and another $2 billion in long only.  In talking to the analysts, they complained that they found it hard to pay for boutique research, even though they find significant value.  Further conversations with the president of the firm revealed the cause.  Pension clients, and pension consultants, scrutinize the firm’s ‘soft dollar’ payments, defined as step out payments to third parties and CSA payments.  The firm has limited commission payments for third party research to 15% of the firm’s commission pool.

The irony of this is that the Securities Exchange Commission clarified in 2006 that soft dollars relates to all commissions paid for research, including bundled commissions paid to bulge bracket firms.   Nevertheless, mutual fund trustees, pension funds and pension consultants continue to zero in on only the unbundled portion of soft dollars: step out payments for third party research and CSAs.  Why?  Because payments to third parties are easier to monitor than bundled research, even though they are a fraction of the commissions spent to purchase research.

So, a proliferation of trading desks continues.  One of the objectives of regulators is best execution, but until regulators address both sides of the commission equation–best research and best execution–this goal will be elusive.


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