The battle for commission dollars got much hotter in 2007 as the buyside changed the way it conducted its execution and research spending.
Since regulators clarified rules on soft dollars earlier this year, a larger number of buyside firms have been embracing client commission arrangements, or CCAs. And that should continue in 2008, says Robin Hodgkins, president of Cogent Consulting, which specializes in commission management. More CCA use will leave many more brokerages out in the cold, watching their lists of trading partners shrivel significantly.
By the end of next year, two-thirds of the 100 most active buyside firms are expected to be using CCAs, according to analysts at Greenwich Associates. Similarly, Traders Magazine found that 55 percent of the 100 respondents to a survey on CCAs said they will have a CCA program in place by the end of 2007. This means a growing number of money managers are taking greater control over where they execute and how they pay their research providers.
Of Cogent’s 100 buyside clients, Hodgkins says, the majority will be driving down their broker lists to an average of about 10 trading relationships by the end of 2008–some from lists numbering more than 100 firms. “The vast majority of buyside firms will be using CCAs,” Hodgkins says. “We’re seeing companies that swore they would never do soft dollars doing CCAs now.”
But Matt Lyons, senior vice president of equity trading at Capital Research & Management, doesn’t expect his firm to be one of them. At a past STA conference, Lyons said he was skeptical about CCAs and planned to keep his relationships with his brokerages. He acknowledged that he would be loath to combine order flow through fewer brokers and would rather spread his orders around to avoid giving a single broker the mass of information implicit in a single large order.
“We don’t use [CCAs], and I don’t suspect that we will,” Lyons said about 14 months ago. “Order flow is valuable to the brokers. That is why they built their models the way they did. It’s huge.” Lyons says that market impact has been the largest cost of trading, and that by giving too few brokers too much information, he would be exacerbating those costs.
With commissions, there’s plenty at stake. The buyside paid almost $11 billion in commissions last year, according to the most recent data available. Of that, almost 27 percent, or $2.9 billion, went to small- and mid-tier brokers. Now, half of those commission dollars earmarked for smaller firms could soon go to the 12 largest brokers because of their CCA programs, says Integrity Research Associates, a consultancy that evaluates research providers.
CCAs in Europe are called commission sharing arrangements, or CSAs. They are essentially the new, more transparent soft dollars. With a CCA, a money manager gets his research from a broker or firm. He then trades with another broker, who sets aside a specified portion of the commission, which will be used to pay the manager’s research firms. For more than 30 years, since the 1934 Securities Exchange Act was amended to include a soft-dollar safe harbor, portfolio managers had mostly been getting their research and brokerage services through the same sellside firms. But after the Securities and Exchange Commission clarified commission dollar use in a no-action letter to Goldman Sachs almost a year ago, that has changed.
The predicted fallout from increasing CCA use should be extensive for brokerage firms. Money managers will have smaller trading lists, larger research lists and will use more hard dollars–or straight checks–to pay for research, according to Karan Sampson, a consultant who covers hedge funds for Greenwich Associates. As more commission dollars go to the bulge brackets and their CCA programs, smaller firms may close their trading desks to focus entirely on research, says Dushyant Shahrawat, research director at TowerGroup, a financial consulting firm.
Over the next year, or so, the bulge bracket firms will be investing in their electronic trading business to handle the expected increase in order flow, Shahrawat says. Simultaneously, smaller and regional firms fighting to keep their existing trading business will also be investing in technology to ensure that their electronic trading departments remain competitive.
According to Hodgkins, research costs will rise as sellside firms turn increasingly to research. They will become more aggressive about the monetary value of services such as access to management and the priority of analyst calls. “Some firms are talking about auctioning research,” Hodgkins says. “Some people are talking about setting specific price lists for that research.”
For the buyside, the unbundling of research and execution has created more transparency as to how much money managers are spending on research, Integrity president Sanford Bragg says. This allows them to determine which firms provide the greatest value. Such transparency helps regulators verify to what degree the buyside is acting in its clients’ best interests.