As the solvency of bank after bank came into question, and bankruptcy, consolidation and acquisition became the trend among large broker-dealers, many buy-side firms were left questioning their client commission agreements (CCAs), or commission sharing agreements (CSAs), as they are known in the United Kingdom.
The buy side has typically used CCAs to consolidate brokerage relationships to ensure best execution while applying some of the commissions from those trades to obtain third-party research. But at a time when market volatility is at an all-time high and big broker-dealers are merging, being bought out or even going bankrupt, the concept of consolidating commission dollars with fewer firms is not as attractive as it was a year or two ago.
"The whole point of CCAs was to simplify the broker relationship and centralize, if possible, and the leading contender for the centralization was usually the largest broker out there," explains Sang Lee, cofounder and managing partner at Aite Group. "After what's happened, perhaps putting everything in the same basket is not such a good idea anymore - a single point of failure is not a good thing. This has led firms to look at opportunities in spreading out relationships."
Lee notes similarities between the changing mind-set around CCAs and the trend to reevaluate prime brokerage relationships. "The hedge funds are taking money out from certain prime brokerages and spreading that money around - really, they're spreading out the risk," he says.
Spreading Out the Risk
Until the markets settle down and there is a clearer view of firms' financial positions, Lee adds, he sees the CCA trend slowing. "We will continue to see the spreading out of risk by spreading out relationships - instead of centralizing - and forging more relationships," he predicts.
"It's an understatement to say that the markets are incredibly volatile, and I think the major issue here is that the markets are behaving extremely irrationally," Lee continues. "Looking at overall brokerage relationships from a commission management perspective, I imagine it's a smart thing to spread out that risk."
According to Lee, one key takeaway from the market turmoil is a focus on better counterparty risk analysis. "All buy-side firms should be taking a close look at their counterparties," he says. "Hedge funds are incredibly concerned with the overall viability of their broker counterparties, and there isn't a technology or platform out there to help take care of it." He points to issues with gathering relevant data from portfolio management, accounting and risk systems, as well as incorporating credit ratings and balance sheet information from counterparties, as major challenges to measuring and mitigating counterparty risk.
Alternative CCA Models
Mark Dimont, head of broker relationship management at Morgan Stanley Investment Management, confirms that the buy side is rethinking its CCA relationships. As a result of the bankruptcies and broker-dealer consolidations, Dimont says, firms that were considering moving to the CCA model have slowed their movement in that direction.
In fact, the CCA model itself could evolve as a result of the current environment into more of a consortium model. Under that model several large firms could come together and anoint a single firm or product to manage an aggregated pool of CCAs. Another option could be the emergence of third-party CCA managers. A large commercial bank that is not already in the CCA or trading business, for example, could form a new subsidiary to provide CCA management services backed by a consortium.
A number of banks have been examining the consortium model over the last year, according to Dimont. "I think you'll find a firm like a State Street [Global Markets] or Westminster [Research Associates] or a global custodial company putting themselves forward as an outsourced CCA manager. They have experience [managing CCAs]," he says, "and it might be an attractive option."
The consortium model would bring together a number of sponsors in the big broker-dealer world that would potentially operate and manage a pool of CCA money. They would be obligated to each other and would consent to cover the agreements should any one participant have financial problems. This would reduce single counterparty risk, as the entire consortium would stand behind a deal, and streamline internal work to manage the arrangements.
Dimont's group started its CCAs in summer 2007 with an initial effort to sign 12 agreements with broker-dealers. To minimize counterparty risk, however, it expanded the list to include the firm's top 50 trading partners. "We're going to see how it shakes out, but I think we'll end up going back to having fewer relationships," Dimont concedes, noting the challenges of managing too many CCA relationships. "If we haven't seen the partner getting any flow or stepping up to the plate, they'll be out."
Dimont says Morgan Stanley Investment Management generally conducts the vast majority of its business with its top 20 trading partners. "The main reason we have all these CCAs is that we don't want to leave money on the table," he says. "But it's difficult administratively to oversee [multiple agreements]." Dimont explains that if his firm trades with a non-CCA partner, the trading partner does not aggregate research credits on Morgan Stanley Investment Management's behalf.
"The beauty of the aggregation model is that we could reconcile and provide payment instructions in one central location," says Dimont. "That's a tremendous benefit."
David Kovacs, chief investment officer, quantitative strategies, at Turner Investment Partners, also sees the existing model for commissions and research dollars changing in light of the new financial landscape. "There is increasing pressure from institutional clients to reduce overall commission rates, and the buy side is going to have to explain paying so much, particularly if performance is deteriorating," he says.
With or without new CCA models, Kovacs sees the buy side increasing its use of independent research providers with the consolidation of the large bulge-bracket firms. "The specialty independent research firms with no investment banking and no conflicts of interest will get a larger portion of the dollars," he asserts. "Those firms may be paid either through soft dollars or check, as firms feel value-add from them and will continue to look to them for research."
As for being prepared, Dimont says, when his team structured its CCA contracts a couple of years ago, it included a clause addressing the issue of bankruptcy or dissolution of a CCA broker-dealer partner. The clause clearly states where the money goes in such events, and while it was not big on everyone's mind at the time, flash-forward to 2008 and it's vital now. "There are no surprises now," he says. "Is it still fiscally responsible to simply leave your dollars with the full-service brokerages?"
Smaller agency brokers can definitely succeed in today's market, Dimont continues. "They have carved out a niche for themselves - the bulge-bracket sales traders with 200 clients covering 300 products have such complex organizations," he says. "But a lot of smaller agency brokers with a refined client list and a focus in core small or mid cap names have thrived and done quite well."
While the concept of CCAs won't go away, Aite Group's Lee adds, buy-side firms will continue to spread out their counterparty risk amid the current volatility. "I could see the small to midsize brokers and agency brokers benefiting from this, as they don't have the risks inherent with the big broker-dealers. I also think the custodians could come out ahead. They're generally thought of as boring and not doing anything risky, but in times like this that's a good thing," he says.
"One of the biggest challenges for firms heading into the CCA model is that data quality is a challenge and requires a lot of work and operations input and so much administration," notes Morgan Stanley's Dimont. "We have a team of people focused on making sure this goes right, but other organizations don't have the scale and could struggle with it."
When it comes to having arrangements in multiple countries with various legal entities, Dimont says, due diligence is key. "The paperwork is different - there's a different contract for different parts of the world, and there is much more variability if something goes wrong," says Dimont.
Dimont's advice to other buy siders dealing with CCAs? "I think Lehman has proved that [bankruptcy] can happen to anybody," he says. "Therefore, with regard to money that you have sitting at other firms, make sure your agreements are tight. If you can, and where you can, ensure you have the proper language in place or the proper understanding formalized with those firms that you're doing business with. Due diligence with your broker partners and the countries and regions where you're doing business is vital."
Turner Investment's Kovacs adds, "A year from now the landscape of Wall Street and the structure is going to be so different, it will be a new era."
Sidebar: What Is a CCA?
Broker-dealers offer both research and execution to buy-side clients through bundled offerings that are paid for through commissions. Under a client commission agreement the research can be proprietary research provided by the broker-dealer or third-party research supplied through the broker-dealer. Buy-side clients stipulate which services they would like the broker-dealer firm to pay for on their behalf, and, using commission credits, payment is directed by the broker-dealer to the appropriate provider.
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