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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.


	Bill George July 23, 2008 11:38 AM PDT Some Problems with Client Commission Arrangements The premise for creating Client Commission Arrangements (CCA) was to facilitate investment advisors’ concentration of trading with an executing brokerage firm which claims to provide “best execution” then allocate some excess commissions generated from these trades (with the executing broker) to pay for third-party services. In my mind CCA’s are problematic for a couple of significant reasons: (1) Although execution analysis and execution evaluation has been attempting to identify and quantify “best execution” for more than thirty years there still is no uniform definition of “best execution” and there is no standardized and universally accepted methodology for measuring best execution. (Does one use value weighted average trade price (VWAP), the Elkins/McSherry method, the ITG Plexus method, Abel/Noser’s approach, Gil Beebower’s SEI Model, or . . . .) And, is “best execution” defined as above median performance, the top quartile or the top quintile of all trades executed by the broker, or can a broker claim to have expertise executing trades in a specific capitalization range or industry group. My point: I suspect there are more brokers claiming to provide “best execution” than brokers who can actually prove they provide “best execution” on a consistent basis. (2) The current structure of Client Commission Arrangements (CCA’s) further institutionalizes the historic competitive advantage full-service brokerage firms’ proprietary ‘services’ have enjoyed as compared to third-party provided services. In the current (U.S.) regulatory environment, and as CCA’s are presently structured, CCA’s provide a cover for the continuation of the tradition of bundling and not disclosing brokerage firms’ proprietary services. While at the same time, CCA’s further institutionalize processes that force the specific identification and detailed disclosure of third-party provided services. This lack of identification and disclosure of full-service brokerage firms’ proprietary services purchased by fiduciary investment advisors’ with their institutional clients’ brokerage commissions makes it difficult, if not impossible, for clients, co-fiduciaries and regulators to monitor and test for fiduciaries’ appropriate uses of institutional clients’ brokerage commissions [under Section 28(e) of the Securities Exchange Act of 1934, and test for conformity with fiduciary duty]. In July of 2006, at the time of the release of the SEC’s “Commission Guidance Regarding Client Commission Practices Under Section 28(e) of The Securities Exchange Act of 1934”, Chairman Cox agreed to “soon issue interpretive guidance on commission disclosure and transparency” during the same announcement several SEC Commissioners and staff members commented on the importance of this “second wing of guidance on the disclosure and transparency of the uses of institutional clients’ brokerage commissions”.(1) The SEC has been reminded of this “promise” of additional guidance several times, but so far, no such additional guidance seems forthcoming. -------- (1) See, Commission Guidance Regarding Client Commission Practices Under Section 28(e) of The Securities Exchange Act of 1934 (July 18, 2006) at > http://www.sec.gov/rules/interp/interparchive/interparch2006.shtml and see, SEC “Sunshine Meeting” July 12, 2006 at > http://www.connectlive.com/events/secopenmeetings/2006index.html