The drive by money managers to unbundle has small- and mid-tier broker-dealers squirming. Whether it is via direct payment or indirectly through client commission arrangements (CCAs), many money managers are determined to value and pay separately for research and execution services. The trend, which results in fewer orders being sent to brokers’ trading desks, is starting to cause pain at regionals and boutiques.
“Anything that distances a firm from its clients is viewed as a threat to the business model,” Doug Woodcock, president of D.A. Davidson & Co.’s equity capital markets group, said at a recent industry conference. “And clearly, client commission arrangements do. Everybody is trying to maintain a comprehensive relationship with their best clients. That includes a trading relationship.”
CCAs create distance between a brokerage and its institutional clients because they eliminate interaction between the broker-dealer’s trading desk and the client. Money managers, which traditionally paid for research with order flow, are now starting to direct more of their trades to a small, elite group of large trading houses. Those firms then pool the commissions and distribute them to the research providers aligned with their CCA programs on a periodic basis.
Generally, mid-tier firms would prefer to negotiate separate agreements with specific clients one-on-one,” Woodcock said. “But the reality is that that is not the way it is going to happen. Pooled commission agreements such as CCAs are the way this will fall into place.” Davidson is a regional brokerage headquartered in Great Falls, Montana.
The disconnect is causing bruised feelings among the brokers that function as “research providers” in the CCAs. Not only are their trading desks getting the cold shoulder, their firms are facing declining revenues. While CCAs now represent only a small portion of these brokers’ revenues single-digit percentages, according to an informal survey conducted by Woodcock that portion is growing.
“It’s growing fast,” Woodcock told attendees at this year’s Securities Industry and Financial Markets Association Institutional Brokerage Conference. “In many cases, it is the fastest-growing component of the revenue stream.” Woodcock, formerly Davidson’s director of research, said he surveyed about a dozen mid-tier brokerages “all with valued research products.”
At one regional, the hard dollar percentage is already in the double digits. Nik Fisken, director of research at Arkansas’ Stephens Inc., says hard dollar payments represented 20 percent of its institutional revenues. “They were up 250 percent in 2006 and 85 percent year-to-date,” Fisken told attendees at the SIFMA confab. For Stephens, one hard dollar is the equivalent of $1.35 in commissions, Fisken explained.
Behind the use of hard dollars to pay for research is a drive by money managers to get best execution. While a given brokerage may provide sterling research, it could be relatively weak on the trading end. CCAs then allow the money manager to use the brokerage for research but bypass it when it requires trading.
That’s certainly the approach at SAC Capital Partners, one of the industry’s largest hedge funds. “We are very focused on best execution,” Perry Boyle, SAC’s director of research, said at the SIFMA conference. “So we’ve had some troubling situations with [brokers] who rank high in our research vote but are terrible on execution. We just can’t pay them [with commissions], and they are not set up to bill us any other way. That is a frustration.” Boyle added that SAC has been pushing “marginal desks to hard dollars,” but none wants to move in that direction. “And when you do go to hard dollars, none of them can come up with the price, so it ends up being a quarterly negotiation very time-consuming. We end up not dealing with them at all, because they’ve made it too hard to buy their services.”
Robeco Investment Management is another buyside shop taking steps to unbundle its payments for research from those for executions. It too has met with resistance from smaller broker-dealers. “We consider our CCA partners to be our core broker partners,” Mark Kuzminskas, Robeco’s director of equity trading, told the SIFMA conference. “Those who were left outside had some ruffled feathers.”
To make the CCA program work, both the money manager and the research provider must agree on a price for the research. That has proved difficult, both sides acknowledge. Valuing execution services has become easier as electronic trading expands, but valuing a broker’s research is a work in progress. Still, for unbundling to flourish, the buyside must be able to put a dollar amount on the research it receives.
A New System
To that end, Robeco has created a system that helps do just that. After every instance of contact with their research providers, Robeco’s analysts and portfolio managers are charged with electronically assessing the quality of the interaction.
Staffers judge the quality of corporate access, conferences, conversations with analysts, salespeople’s ideas and special projects done with brokers. The votes are tallied, and a research payment for every broker is determined. Robeco also uses its payments for third-party research providers as a guide.
Every Robeco broker is paid a base execution rate to start, Kuzminskas explained. Then, if the broker has “research traction” with Robeco, the desk will add extra commission to pay for that research.
This cost-plus or execution-plus model is starting to become the standard for transactions, according to one of the largest operators of CCA programs. “We are seeing more and more of these deals put into place every day,” said Tom Conigliaro, a Goldman Sachs managing director. “It is certainly not the majority of the deals we see, but it is at the forefront for many of our global clients.” He explained at the SIFMA conference that the cost-plus pricing approach began in the U.K., which is “ahead of the curve.”
With unbundling steaming ahead, small- and mid-tier firms face some business issues, Davidson’s Woodcock noted. Broker-dealer research departments must work harder to maintain customer loyalty, he said, but the biggest impact will be on the trading desk. The allocation of a firm’s resources to trading will be re-evaluated, he said.
“Managing the trading desk infrastructure is a big business issue,” Woodcock said. “Your order management system, your FIX connections all of the costs associated with trading have to be managed as execution becomes associated with less than 100 percent of your revenues.” For some firms, any negative impact on their trading desk might not be limited to the desk, Woodcock’s survey discovered. Those broker-dealers underwriting securities offerings rely on trading departments to distribute and make markets in those issues. They fear any impairment to their trading desk could “diminish their distribution and ultimately impact their ability to lead transactions.” The backlash against CCAs has begun at some broker-dealers. Said SAC’s Boyle: “Firms with an investment in execution resources, in their desks, are deathly afraid of being CCA’d. They are really fighting it. If I go to one of these guys and I start paying through a CCA, they are not going to tell me right now, but I guarantee you my level of service will go down.”