New York, NY - In the past few months, many journalists (ourselves included) have extolled the various virtues of Commission Sharing Agreements (CSAs) and their near cousins, Client Commission Arrangements (CCAs). However, very few have focused on negative consequences that adopting CSAs might have on the money management community. Below we provide an overview of these issues:
1. Reduced Competition
The first negative consequence we need to discuss is not really a result of CSAs, but rather it is a result of the rapid move to unbundling the execution from the research decisions. In the US, many money managers have quickly reduced their number of trading counterparties – from 260 to 60, 300 to 30 or 250 to 20 execution partners – under the belief that they would be focusing their business with a smaller number of "best execution" providers.
It is hard to argue that the broker that was 299th on a money manager's list was probably there because of the quality of the research they provided, not the quality of their execution capabilities. However, it not so easy to make that argument with the 65th broker, the 35th broker, or the 25th broker.
In addition, this rapid consolidation of execution into the hands of a smaller and smaller number of brokers, might not benefit money managers over the intermediate to long term as reduced competition could lead to a number of adverse consequences, including rising execution costs.
It also must be noted that a number of the largest brokers that are benefiting from this consolidation of execution providers are also in direct competition with the buy-side through their own asset management divisions, through their proprietary trading desks, or through their growing hedge fund operations. Increased consolidation enables these firms to see a greater percentage of the buy-side clients' flow – a development that could be beneficial for the sell-side and detrimental for the buy-side.
2. Falling Research Quality
It is also clear that the proliferation of CSAs will lead to a deterioration in the quality of research from some previously high quality research brokers. This assertion seems somewhat contradictory as the market generally believes that good research providers will be rewarded under CSAs with more research commissions.
However, this view overlooks the actual economics of the research business. Today, many of the world's top investment analysts work at large integrated investment banks that derive revenue (and profits) from a wide range of business activities. It is this diversity of business that enables these firms to afford the best and brightest – even if these firms' research businesses cannot support themselves purely from their equity capital markets businesses.
Unfortunately, the use of CSAs could lead some second tier execution firms to lose a significant amount of their execution revenue (although they would maintain their research revenue). And while it would be easy to say that these firms should just "close down" their trading desks – such a move could have devastating consequences to their overall business as many investment banks compete on the basis that they can also make markets in the stocks they finance or bring public. In other words, the squeeze on the trading business would have a knock on effect for the whole company.
But, some might argue that this should have no impact on the good research they produce. This, however, is not the case. The revenues and profits lost from trading (and other related businesses) actually supported the salaries, bonuses, infrastructure, and other related costs of running a high quality research business. The loss of these profits would be felt by the analysts – and impact that could prompt many of the best analysts to leave for greener pastures.
Subsequently, the consolidation of execution partners caused by unbundling and the use of CSAs would lead, in some cases, to the deterioration in research quality at many second tier and boutique brokers and investment banks.
3. Negotiating Disadvantage
Probably the single greatest negative consequence that using CSAs could have on the buy-side is the severe disadvantage it puts them at when negotiating with their brokers over the value of their research. This is due to the asymmetry of information (some call this information leakage) that exists between the two parties.
We have been asked by numerous buy-side executives if we can help them determine if they are paying the right amount for their research they are getting. When asked why they need our help, we learn that they know they are paying the "right" amount for many alternative research services because these services have an actual rate card.
Unfortunately, these same firms have no such idea when it comes to research that is sold in a "bundled manner" – including the research provided by many bulge bracket CSA brokers. These buy-side firms only know what they paid last year in total commissions -- purportedly to receive execution and research services. Consequently, it is very difficult for the buy-side to determine how much they should actually pay for these bundled research services.
The CSA broker, on the other hand, in is a very different position because they know what everyone else pays for their service (including their most appropriate peers). In addition, the broker knows what the buy-side firm is paying for other alternative and third-party research that they are being asked to pay for through the CSA mechanism.
As a result, the CSA broker has a distinct advantage when negotiating with their buy-side clients over how much they should be paid for their research. This means that buy-side firms will probably continue to overpay for their sell-side research – at least until this asymmetry of information is resolved.
Posted at 11:26 am by mwmayhew
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