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 U.K.
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 any more -- 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 re-evaluate 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.
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 put 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.