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October 4, 2007

Surviving the CCA Storm

Small and Mid-Tier Brokers Brace for Loss of Order Flow

By James Ramage

In June, Thomas Weisel Partners, a midsize investment bank based in San Francisco, purchased software from vendor FlexTrade Systems that allows its portfolio trading desk to better manage the timing of its trades. Last month, Weisel signed a deal with Townsend Analytics to distribute its algorithms through Townsend's RealTick trading platform.

In both cases the news is unremarkable, but what is significant is that a year ago, Thomas Weisel didn't even have an electronic trading group. That the bank, best known for underwriting and researching small-cap growth stocks, is now

plunging head first into low-touch trading speaks to its determination to remain a trading force in a world where order flow is slowly moving away from small and mid-tier broker-dealers.

The buyside's use of client commission arrangements (CCAs) is eating into the order flow previously sent to boutique and regional houses. Set up by large trading houses, the arrangements allow money managers to consolidate their trading into fewer (and larger) hands. The buyside can now obtain research from the Weisels of the industry but direct their trades to the Morgan Stanleys. And buysiders are increasingly asking their smaller research providers to accept payment in hard dollars rather than order flow.

At Risk

In the face of this, some of the at-risk broker-dealers are taking steps to beef up their trading or cutting their exposure to check-wielding money managers. Others are doing nothing at all, maintaining that their existing trading services are adequate.

For Weisel, in addition to enhancing its electronic trading, the firm is refusing to take CCA checks for its research. It sees itself as not just a research shop, but also a capable and value-added trading house. More specifically, it has been a liquidity provider in small- and mid-cap names, growth names, consumer health-care technology, and alternative energy and financials, and intends to remain one, says Stephen Blatney, Weisel's head of electronic trading. As the CCA presence has grown, the firm has built a commission management department to write CCA checks that now accounts for a small percentage of their business, Blatney says. The breadwinner, though, remains execution.

"Having a good quality execution platform is what it's all about," he says. "We feel very strongly that the role we fill is still an important and a vital role for the overall markets."

To many small and regional brokers, CCAs are massive thunderheads they see on the horizon moving toward them. Also known as commission sharing arrangements, or CSAs, and soft dollars, CCAs enable the buyside to get research and execution from different sellside firms. They typically work by having a money manager first obtain research from a broker or firm. The manager then trades with another broker, who sets aside a portion of the commission to be used to pay the manager's research firm.

And as an increasing number of money managers plan to employ CCAs over the coming 12 months, smaller and regional brokers say their core businesses could face a daunting array of possible storms as a result. At worst, those firms say, CCA fallout will lead to order flow consolidation to the largest firms. That could mean shrinking commissions, scarcer liquidity, poor execution quality in the less liquid stocks many of them cover, and even trading desk and firm closures.

By the Numbers