New York, NY - It is clear that many buy-side firms love the flexibility that Commission Sharing Agreements (CSAs) and Client Commission Arrangements (CCAs) bring them. These firms explain that using CSAs or CCAs enables them to trade with the best executing partners, while separately paying the firms that provide them with the best research. However, not everyone is rejoicing over the increased adoption of CSAs and CCAs. In fact, a number of brokers have found that clients’ use of CSAs and CCAs has hurt their business in a variety of ways.
Adoption of CSAs On the Rise
According to a release of Greenwich Associates’ 2008 U.S. Equity Research survey, more than 45% of buy-side institutions say they have implemented CSAs or CCAs - up from the approximately 25% that reported they used these same products last year. Another 5% of the buy-side institutions surveyed say they plan to establish a CSA or CCA over the coming 12 months.
Even though a significant number of US buy-side firms have implemented CSAs or CCAs, many users are not utilizing them heavily. In fact, according to the Greenwich survey, among active users of CSAs or CCAs, the share of commissions that flow through these arrangements grew to only 23% this year, a total that is expected to rise to 27% in 2009. Overall, U.S. buy-side institutions are directing an estimated 16% of total U.S. equity trading commissions through CSAs or CCAs. This total is expected to increase to 20% of overall commissions in the coming 12 months.
Number of Execution Partners Slashed
Based on the Greenwich survey, buy-side firms that have implemented CSAs report that they have stopped trading with between 18 and 19 firms. These firms now get paid for their research via CSAs. Mutual funds were the most aggressive in consolidating their trading relationships through the use of CSAs by dropping an average of 32 execution providers. Pension funds and endowments were reported to have dropped almost 27 trading partners, on average. In addition, larger firms were more active in shortening their broker lists than smaller firms. According to the Greenwich survey, buy-side firms with more than $50 million in commissions cut almost 32 trading counterparties.
Most writers on this topic (ourselves included) have projected that the bulge bracket firms would be the biggest winners from CSAs and CCAs, while the biggest losers in this consolidation of execution partners would be the regional and smaller brokers. However, data from the most recent Greenwich survey does not completely support this contention. While it is clear that larger brokers like Merrill Lynch and Lehman Brothers were cited as the top two executing brokers in the U.S. institutional equity markets, a few specialists like Instinet, BNY ConvergEx and ITG were able to compete quite strongly against the bulge bracket firms.
Unfortunately, any firm that gets cut from a client’s broker list, even if they receive a check from a CSA provider for their research, suffers significant financial pain. For example, CSA brokers generate a profit from providing execution services. Thus, losing clients’ trading revenue means taking a hit to their bottom line profits. In addition, CSA brokers often earn more for their research by retaining a portion of the CSA pool than if they got a check for the same research. In addition, the CSA payment process can cause cash flow problems for smaller brokers, because they generally get paid quarterly for their proprietary research rather than at the time of the trade.
How Much is Paid Away?
Even if a broker retains a client’s commissions by offering CSAs and CCAs, they typically see a significant shrinkage in their margins as clients require them to “pay away” a considerable amount of the commissions they receive to third-party brokers and alternative research providers.
According to Greenwich Associates recent survey, U.S. brokers typically keep an average of 30% of the commissions they charge clients to pay for execution services. In addition, brokers who also produce research generally keep 20% to compensate them for their proprietary research. Consequently, these firms pay the remaining 50% to other brokers and alternative research providers through the pool of commissions collected via the CSA.
Consultants at Greenwich Associates suggest that the U.S. brokers are unlikely to continuing paying so much of the commission away to third-party brokers and alternative research providers. For example, UK brokers keep 60% of the commission (35% for execution and 25% for proprietary research), thereby paying out 40% to third-party research providers.
Regardless of whether they keep 40% or 50% of the commission, brokers’ margins are much lower offering CSAs and CCAs than in the old days when, at most they offered to pay close to 10% of all commissions in “soft dollar payments” to pay for their clients’ use of third-party research. Thus, the only way CSAs and CCAs make sense for brokers, is if they get increased trading volumes to make up for the lower margins.
Summary
As you can see, Commission Sharing Agreements and Client Commission Arrangements, while useful for buy-side firms to separate the trading and research purchasing decision, can be quite painful for a number of brokers. As buy-side clients use them to consolidate their trading partners, some brokers find themselves on the short end of the stick, losing execution business. However, even if they retain the trading business, many brokers are finding it less and less profitable than it was in the past offering CSAs and CCAs. These brokers only hope they keep clients happy and gain in volume what they lose in margin.
