Surviving the CCA Storm

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

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

Experts’ projections are unforgiving. The buyside paid the sellside $10.9 billion in U.S. commissions in 2006-of which $2.9 billion went to second- and third-tier firms-according to the most recent data from investment research specialists Integrity Research Associates. Integrity also estimates that through CCAs the top dozen of the largest brokerages could grab as much as half of the commissions that second- and third-tier firms earned in 2006. Buyside broker lists have been shrinking for years for a number of reasons, and more CCAs would only hasten this trend.

So far, the buyside has been gradually adopting CCAs, and there has been a range of acceptance, according to a number of surveys within the industry. More than 30 percent of the buyside is using CCAs to pay bills, according to a recent Greenwich Associates survey. Over the next 12 months, that number should rise to 59 percent, says Jennifer Litwin, Greenwich’s director of institutional marketing.

The results of an electronic survey conducted by [Traders Magazine], published in April, weren’t dramatically different from Greenwich’s. It reported that 43 percent of buyside firms were already using CCAs, with another 12 percent slated to use them by the end of the year-or 55 percent by January 1. (The [Traders Magazine] survey received 100 responses, including 77 percent from traditional asset managers; 19 percent from hedge funds and 4 percent from pension funds.)

Earlier this summer, a TraderForum survey that addressed CCAs found that 61 percent of the buyside will have established these accounts by the end of the year. TraderForum, a conference and research provider for the buyside, had 100 respondents, with 30 percent coming from hedge funds.

Other experts, such as Dushyant Shahrawat, research director at TowerGroup, say CCAs and other forces will prompt a shakeout in the industry. He says the “oversupply of trading shops” in the U.S. will be trimmed by up to 20 percent over the next three or four years.

But size alone may not be the determining factor in that consolidation, says Randy Cass, chief executive of First Coverage, a research analysis technology firm. Quality counts, he says. “If the small trading desk is good, they’ll continue to get flow,” Cass notes. “It all leads to an environment where, if CCAs are the way of the future, the sellside-whether a bulge bracket, mid-tier or boutique-has a much greater onus on it to demonstrate that the services it is providing are adding value to be worth more than execution rate.”

B. Riley & Co. provides a concrete example of how small desks can compete in a CCA world. In August the Los Angeles-based firm was the axe, or top trader, in 70 percent of its top 20 names, according to Nasdaq data.

Know Thy Niche

Survival, industry experts say, starts with knowing and growing the niche each brokerage firm has carved out for itself-in specific sectors and industries, as well as in small- and mid-cap names. But that alone may prove insufficient, so small and regional firms have also been proactive. Some, like Weisel, are fighting back by beefing up their trading desks or refusing CCA checks. Some trading desks are shifting their resources to focus business on mid-tier buyside clients who have yet to embrace CCAs. Some even plan to add traders in the coming months. Others are doing little more than sticking with the business models that have added the most value in the past. The firms interviewed say they are currently seeing only a few CCA checks for their research, and none has witnessed a drop in payments by order flow so far.

“People are going to what they’re good at,” says Richard Parker, managing director and head of trading at Stanford Group Company. “You’ve got to live where you’re adding value, where you have your expertise, because there’s not that much free business out there.” Clients who buy research aren’t “forced to trade with you anymore,” he adds.

CCAs are here to stay, and Stanford Group Company expects to be right there with them. When Parker arrived three years ago, the firm had 10 traders. Today it has 25. Over the next 12 months, he expects it to add another six or seven. And though the firm considers itself a research provider first, trading pays the bills, Parker says. They’re still trading with the firms with which they’ve signed CCAs, he adds. In 12 months, Parker expects the buyside will still prefer to trade with those who can provide liquidity.

Necessary Adjustments And neither is the sellside forced to trade with the buyside. Like Weisel, Canaccord Adams is eschewing checks. There, the strategy has involved re-allocating resources from its larger buyside clients to midsize ones, where CCAs weren’t compulsory, says President Mark Maybank. CCAs have caused commission compression in the firm’s “mega-cap” client segments, or those managing more than $80 billion in assets, he notes. The broker’s research is highly regarded: Integrity Research recognized its prowess in small caps alongside four other firms in its latest 104-page report on the best in the sector. But Canaccord Adams doesn’t sign CCAs, and expects to be paid for its research in flow. “The one thing about us requiring to be paid in flow means that we have to be able to provide strong value-add,” Maybank says. “That means strong levels of insight in our selected stocks of focus on our trading and sales trading desks, and the use of strong and robust electronic trading tools to ensure we can provide that same level of best execution as others.”

It’s no mystery that if the buyside loses interest in smaller or regional firms’ trading desks, the overall viability of the smaller trading houses will be threatened. And without a trading house, those smaller and regional firms may lose out on a huge income generator: underwriting IPOs. Firms cannot pitch issuers to lead IPOs if they don’t trade stocks, and hence, make markets to help get the nascent stock off the ground.

Desk Threat

Where [losing] order flow hurts the smaller firms is, if they are seeing their trading dry up, then the firms may decide they’re going to re-examine the costs of supporting a trading desk, transfer that into research and close down the trading desk,” says Paula Mahoney, director of equity trading at Pittsburgh-based BNY Mellon Wealth Management. “As long as the (research) firms are involved, they’ll need support from the trading desks, but they may not see the order flow paying for research commitments that they perhaps have seen in the past.” She says she doesn’t anticipate her firm’s brokerage list to drop from its steady number of 75 trading partners.

Still, despite consolidation and technology advances, the trading desks at many small and regional brokerages claim they have not yet experienced appreciable order flow loss.

Commission Concerns

By focusing on specific sectors and small- and mid-cap names, they’ve been able to continue to use research to draw flow, despite a small number of CCA checks starting to show up at their desks. “I have seen that,” says Knut Grevle, head of trading at B. Riley & Co. “Instead of a larger mutual fund or institution trading with us, they would usually go through the bulge bracket firm and then send a check. But it’s such a small revenue stream for our firm that a lot of the trading is still done through us.”

The aggregation of trade flow in the bulge bracket is creating a downward pressure on commission rates, according to traders. The more a buyside institution concentrates its commissions at one firm, the less that broker-dealer is willing to accept per share, says Patrick Fay, director of equity trading at D.A. Davidson & Co., based in Great Falls, Mont. D.A. Davidson has seen its payments via checks in hard dollars increase from nothing to up to 16 percent in a couple of years, Fay estimates. Small brokers say the CCA trend is not only bad for them, but for the buyside as well.

Canaccord Adams’ Maybank has seen a deterioration of market efficiency since CCAs have risen in popularity. By his figures, historically, a number of markets aren’t neutral to trade in anymore, and even have experienced trading losses of around 0.20 cents a share. And Canaccord Adams has seen that negative bias increase by half a penny over the last two years, to about 0.70 cents a share. So, while some of the large accounts have been paying less in overt transparent commissions, Maybank says, they have been hurt on the back end with a market execution loss of half a penny in the last couple of years.

This, he adds, is largely due to an element of what he calls “front running or trade anticipation” or something that creates a negative bias to a neutral trade execution.

“While CCAs have been funneling and focusing trade share into a more concentrated set of dealers, we’ve also seen an increase in negative market impact of trade execution,” Maybank says, “which would imply that those mega-large dealers that the trade flow is being concentrated in have certainly proprietary algorithms, or anticipatory algorithms, or proprietary trading mechanisms that are impacting neutrality of the marketplace.”

Committing Capital

D.A.’s Fay makes the point that, as CCAs pull more order flow away from the small brokers, there is less of an opportunity for them to find the other side of a trade, and consequently, less liquidity. He describes how trading today presents unfavorable scenarios for participation and committing capital, compared to the heady times of 20-cent spreads and buyside orders for 10,000- and 100,000-share bids and offers.

By comparison, he says, these days of one- or two-penny spreads are usually only good for 100-to-200 shares, making brokers less willing to commit capital with such reduced spreads.

“In the old days, you had six places you could call for liquidity,” Fay says. “Now, am I going to provide liquidity to someone who pays us all the time through CCAs? Why? There’s no advantage in it to me, or no percentage in it, because I’m not going to really see the flow. I’m only getting that call probably as a last resort, if they’re using CCAs all the time. And it tells me there’s a good chance I’m going to lose on every single share that I print.”

Service And Executions

On its face, if the buyside can get its research and execution from different firms, and is more transparent in how it does so, it should be good for investors, regulators and markets as a whole. But small and regional brokerages say they still expect to be able to fill both of those needs through service and best execution. And despite the fact that some trading desks may shrink with increased CCA use, firms will always want to trade with experts in the smaller-cap names that Wall Street either doesn’t cover or bank from a research perspective, according to John Meserve, a director at agency broker BNY ConvergEx Group responsible for its research and commission management businesses.

“Take a firm that traffics in small or micro caps, or regional securities,” he says. “They brought them public. They know where all the securities are. They know where the liquidity is. They know the company the best. There will still be a place for them, but it might be a different, skinnier model.”