The proliferation of commission sharing agreements used by institutional equity investors around the world is placing pressure on the small brokerage model, as well as causing administrative headaches for buy –side institutions, according to a research report from Greenwich Associates and Frost Consulting released this week.
A growing number of institutional investors globally are using CSAs, a vehicle through which an investor can instruct the executing broker on an equity trade to pass on a portion of the "research commission" associated with that trade to third-party research providers — including broker dealers or independent research providers.
In 2012, global CSA commissions are estimated to reach $12 billion, which is about half of the total annual asset manager equity spend of $25 billion globally, estimates Greenwich Associates, a provider of research-based strategy management services for financial professionals. Traditionally, commissions charged by a brokerage firm “bundled” the cost of trade execution, research and advisory services provided to the investor client by that broker. In recent years, those research and execution costs have been unbundled by a combination of regulatory steps and evolving market practices, notes Greenwich.
However, CSAs are growing everywhere as asset managers, investors and regulators are valuing the resulting efficiency and transparency.
CSA penetration is highest in Europe mainly because the United Kingdom became the first country to mandate the arrangement in 2003. Since 2006 onward, CSA penetration in Europe, usage nearly doubled from 21 percent to 48 percent of institutions, and by 2012, a little more than 40 percent of total commissions were being allocated to CSAs. While, the SEC did not sanction CSAs until 2006, and other factors slowed it down, by 2012, more than 82 percent of the U.S. asset managers surveyed by Greenwich were using CSAs. At the same time, pervasive use of CSAs is actually creating some new headaches for institutions in terms of the increased administrative burden associated with managing the distribution of commission payments among multiple executing brokers and research providers.
“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,” commented Greenwich Associates Analyst Kevin Kozlowski in the research release. “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.”
As institutions gravitate toward using CSAs, the average number of cash execution counterparties used by asset managers has declined by 17 percent in the last five years. As a result of institutions using fewer executing brokers, small brokers with narrow geographic capability and no specific execution liquidity advantage are at increasing risk of being compensated for their research via CSA payments rather than via execution.
Greenwich maintains this will force smaller broker dealers to address their trading/sales capacity as the proportion of revenues from CSAs rises. What’s more, since CSA payments are often frequently at lower rates than the previous execution-based relationship, brokers may be forced to reconsider their entire cost base against the new revenue model, advises Greenwich.
Even the largest investment bank could feel the impact f CSAs becoming a growing proportion of the total $25 billion equity pool spend. The quicker the investment banking market share of $25 billion per year equity pool decreases, the higher the pressure on capital allocated to the cash equities business segment. Asset managers in turn will look to diversify their sources of research as they fact more scrutiny from pension fund clients over research spending.
“Undoubtedly, commission sharing between brokerages and specialist research providers is going to further evolve over time,” stated Neil Scarth of Frost Consulting, a London-based consultancy specializing in equity research procurement and unbundled commission optimization strategies. “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.”