Getting To The Pool

CLSA’s Global Head of Trading and Execution, Andrew Maynard, and COO of Trading and Execution, Joakim Axelsson, delve into the nuts and bolts of setting up and running Commission Sharing Agreements.

Commission Sharing Agreements (CSAs) between the buy- and sell-side are, in concept, an invaluable tool as they facilitate the unbundling process thereby freeing client’s trading desks to seek best execution.

While the regulatory frameworks across Asia have not developed to the same extent with respect to unbundling and CSAs as they have in Europe and the USA, as a tool CSAs are becoming increasingly common in the Asia-Pacific markets including Australia and Japan. Asian funds seeking to attract international money for management in Asia need to demonstrate to their clients that they are implementing best practices and both CSAs and unbundling integral to the process. So what we are now seeing is a broad acceptance of CSAs in markets which do not necessarily regulate unbundling and best execution. With money becoming more mobile globally, the growth of CSAs in Asia is inevitable as they are a mainstay of the global investment process. The necessary regulatory frameworks will follow – and the challenges to both the buy- and sell-side of administering CSAs will continue.

In Asia, we have observed first-hand the evolution of the CSA business, and over time as the penetration has grown, both the benefits and the challenges of implementing and managing CSAs have become more apparent.

The trading processes within the industry are evolving rapidly. There is far more focus on execution quality from both the buy-side and sell-side traders. Combining this increased focus on execution quality with the technology advances happening in parallel allow far greater transparency about the quality of the trade in real time. This results in a very different level of engagement between the buy- and sell-side traders about the trades, which is very healthy. In this respect, CSAs have achieved the objective of ensuring that the ultimate end investor is receiving an enhanced quality of trading, i.e., best execution.

Clients have implemented their best execution process quite differently. At one extreme are those clients who do not use CSAs and have completely detached their trading desks from their investment management teams to the point where the client’s trading desks are not allowed to know how the various fund manager ranks each brokerage research. To these clients, having best execution is all that matters. While this model certainly ensures the traders have freedom to seek best execution, it can have unintended consequences as brokers who do not receive payment for their research and advisory services over a period of time will naturally have to reduce their service levels to these types of clients. To take this to the extreme, an argument can be made that brokers should not provide any research and advisory services to these types of client.

More common are those clients who implement systems and processes to value each of the services they receive from their brokers. These clients manage their payment process very carefully to ensure that they pay the correct amount for services received and any commission left over is ‘jump ball’ based upon pure execution quality at a lower commission rate.

Finally there are those clients who have yet to formalise their broker ranking, valuation, or execution processes. These clients, while more informal, can be equally demanding from a best execution process, it is another way to achieve a similar best execution result.

From a broker’s perspective each of these client processes has to be catered for and of course that means greater administration, more operational complexity and therefore more costs for brokers. While global commissions are falling, brokerage expenses are indirectly being increased by greater regulation. In some instances another party is being introduced to the chain as CSA aggregators have spotted an opportunity to inject themselves into the process flow – again at a cost.

One of the issues facing the sell-side is that in receiving a CSA cheque, the broker is not actually doing the trading. No broker likes to receive CSA payments over the client trading flow. The sell-side wants to be involved in the trade, as not only does it deepen the relationship with clients; the natural liquidity provides opportunity for further flow and crossing. When an account pays a CSA cheque in lieu of commission, we question the reason. Does it mean that the buy-side trader doesn’t think we offer best execution in that country or in that sector? Either way it can be read as a signal that we need to improve our execution capabilities. It also ensures that brokers offer all the various avenues of execution, every different pool of liquidity, every different connectivity vendor, etc.

Brokers that are not in the top tier of execution, those that cannot afford the regional infrastructure and technology platform necessary to compete, or those brokers that are relying on CSA cheques alone, are operating in a very dangerous space – particularly in these times of lower liquidity.

The buy-side trader has to focus more on the implementation and metrics of the trade than the research payment and therefore allocates trades accordingly to ensure best execution. This is why brokerages which have historically been known for their research product are now forced to make a decision. Do they become a ‘research only’ house receiving cheques? Or do they compete in the execution space?

Major brokerages on the sell-side with both execution and research offerings have had to make a range of necessary investments over recent years to remain at the top of the execution brokerage list. On the other side of the equation, being a CSA broker administering regular payments for clients requires a significant infrastructure spend to maintain a professional service; however these costs are somewhat offset by the additional flow.

Another problem faced by brokers is that analysing client profitability has become far more complex. Clients who pay commissions through trading for further pay-away via CSA often vary the instruction dates and the payment amounts. As a result it is becoming increasingly difficult to project net profitability per client, which of course results in it being more difficult to gauge the level of service to provide to clients. To add further difficulty, if you are receiving CSA payments on a quarterly or semi-annually basis, this lumpy revenue flow can also impact resource allocation.

It is important that both parties understand what the CSA is trying to achieve and the metric the client is trying to develop so that you can resource the client properly. So from the sell-side perspective you now need to look at how to allocate internal resources when your income stream is no longer as clear cut.

Interestingly there is no sell-side consistency as to who manages the CSA process internally. In Asia the process has developed somewhat organically and we see it as an area which needs to be managed by the front office.

While the sell-side has many challenges to consider, the buy-side has it no easier. The buy-side has to find answers to some very difficult questions, what each broker’s research is worth to us, what is execution worth to us? In addition, after the recent FSA consultations, much of the buy-side has to look into what is corporate access worth, what defines corporate access and how do they pay for corporate access going forward. These are structural changes that need evaluation and global implementation across many regulatory frameworks.

For all the challenges and issues however, we don’t believe the system is broken. CSAs remain an incredibly valuable tool allowing the buy-side to manage their commission pool, rewarding those brokers who provide value and allowing their trading desks to achieve best execution.

CSAs are not new, but perhaps only now that they have been widely adopted and implemented are some of the complexities and implications coming to the forefront, and as always the industry is changing to adapt to them.

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