The increased use of commission sharing arrangements–CSAs–by institutional equity investors worldwide could force smaller brokerage houses to re-examine their business models. That’s the conclusion of a report by two industry consultants.
Asset manager annual equity spending is at $25 billion globally and the vast bulk of those expenditures are paid with brokerage commissions generated by equity trades, according to Greenwich Associates, one of the consultants. Traditionally, the commissions charged by a brokerage firm covered the cost of both trade execution and the equity research. The advisory services have been provided to the investor client by that broker. In recent years, however, those execution and research costs have been “unbundled” owing to regulation and evolving market practices.
Global CSA commissions are estimated to reach $12 billion this year, according to industry estimates.
A growing number of institutional investors around the world are using CSAs. They allow investors can choose which broker they want to execute a trade through. They pay a separate research provider, either a broker-dealer or independent research provider. This has given institutional investors the ability to pay their research chits and still trade with their preferred broker.
The increased use of CSAs has hurt the smaller brokers. Volume and commissions have dropped. Brokerages have to contend with more costs associated with managing the distribution of commission payments among multiple executing brokers and research providers, according to Greenwich Associates analyst Kevin Kozlowski and co-author of the report.
“A continuing challenge for regulators and all market participants will be to develop a market infrastructure to effectively cope with the CSA segment’s rapid growth,” Kozlowski said. “There is no central mechanism for managing or matching these trades which poses fiduciary and regulatory risks for asset managers and asset owners as well as operational nightmares best described as bilateral spreadsheet chaos.”
Due in large part to the proliferation of CSAs, the average number of cash execution counterparties has declined by 17 percent in the last five years. As the number of equity execution counterparties used by asset managers decreases, small brokers are at risk. They are the ones with narrow geographic execution capability and no specific execution liquidity advantage . They are at increasing risk of being compensated for their research via CSA payments rather than via execution. The consultants warn that could cost them.
This will be force them to address their trading/sales capacity as the proportion of revenues via CSAs rises. Furthermore, as CSA payments are frequently at levels below the previous execution-based relationship, firms may need to reconsider their entire cost base against the new revenue environment.
This has been happened already in the equities market this year. Indeed, several brokers such as WJB Capital and Ticonderoga Securities have shut down. Even bulge firm Nomura Securities International, consolidated and transferred its equities business to its agency-only sister, Instinet.
Aside from Nomura, the rest of the bulge and mid-tier shops have managed to hold their own, so far. But as trading volume remains low and commissions static, these firms could also see more difficult times ahead.
The report said that the quicker the investment banking market share of the $25 billion per annum equity pool decreases, the greater the pressure on capital allocated to the cash equities business segment. Asset managers in turn will look to diversify their sources of research. They face more scrutiny from pension fund clients over research spending and look to maximize alpha generation, according to Frost Consulting’s Neil Scarth, the other author of the report.
“Undoubtedly, commission sharing between brokerages and specialist research providers is going to further evolve over time,” Scarth said. “Various jurisdictions will eventually agree on principles that would converge and shape into a broader system. Both buy side and sell side constituents will have their work cut out to optimize as much value as they can from this evolution.”
CSA usage is highest in Europe as the United Kingdom became the first country to mandate the arrangement, known as unbundling, back in 2003. Greenwich research has shown that since 2006 CSA usage there has more than doubled to 48 percent from 21 percent. Upwards of 40 percent of total commissions have been allocated to CSAs this year.
Meanwhile, in the United States unbundling is not mandatory but its usage has grown. This year about 82 percent of the U.S. asset managers surveyed by Greenwich Associates were using CSAs.
