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The Buy-Side Dilemma: Research vs. Execution

Commission-sharing arrangements are a big trend in the U.K. Now, the buy side is evaluating CSAs as a way to pay for research and consolidate their trading relationships in the U.S.

For years, buy-side traders have struggled with the conflict over how to pay for quality independent research while choosing the broker that is most qualified to execute trades. In traditional soft-dollar arrangements, to pay for research, buy-side firms have executed trades directly with research providers that also are broker-dealers with a trading desk.

But now there may be an alternative to trading through research providers, which often lack the expertise in trading, or the advanced electronic trading technology and analytics that buy-side firms associate with best execution. A new soft-dollar arrangement is gaining traction on the buy side that allows money managers to separately pay the executing broker for trade execution and ask that broker to allocate a portion of the commission directly to an independent research provider.

The practice, implemented as commission-sharing arrangements (CSAs), took off in the United Kingdom about a year ago, after the U.K.'s financial markets regulator, the Financial Services Authority (FSA), issued new guidelines in July 2005 calling for more commission transparency. "This is a trend, and the impetus seems to actually come from the multiyear investigation into commission spend by the FSA in the U.K., which was looking at redefining or providing a better definition of soft dollars as well as CSAs, and better unbundling of research and trading commissions," says John Feng, a consultant with Greenwich Associates, a financial services research and consulting firm in Stamford, Conn.

Meanwhile, the U.S. Securities and Exchange Commission (SEC) published guidelines consistent with the FSA's work on client commission practices on July 24, 2006, clarifying which research and brokerage services are eligible under Section 28 (e) of the Exchange Act for soft-dollar payments. Recognizing that market participants operate abroad, particularly in the U.K., the SEC guidance said it wanted to reduce the compliance burden on participants that are under multiple regulatory regimes.

Though CSAs have been offered by agency brokers in the U.S. for several years, "They are a relatively new animal as far as popularity from the buy side," says Michael Mayhew, CEO of Integrity Research Associates, a Darien, Conn.-based research firm focusing on the buy side. The CSA arose in the U.K. as a tool specifically for buy-side firms to continue to conduct the best possible execution and to take the pooled commission to compensate both research firms and other service providers that are eligible to be paid by commissions, according to Mayhew.

Since many U.K. money managers have rapidly adopted CSAs, and the SEC has made it simpler for executing brokers to offer commission programs, CSAs have become a hot topic on the buy side. The difference between traditional client commission arrangements and the new U.S.-based CSAs is that instead of requiring brokers to set up complex structures involving introducing brokers and multiple clearing arrangements, the SEC's new guidance will allow the broker executing the trade to allocate commissions to the research provider.

Keeping Executing Options Open

"This is the No. 1 topic being discussed on the buy-side trader's desk," says John Meserve, director of BNY ConvergEx Group. "The SEC made clear that you could trade at one place and pay for research anywhere," he explains. "The SEC is suggesting that you have to have best execution first, and there are no more excuses that you have to trade with that broker first to pay for this research."

"The overarching reason we use [CSAs] is that they enable us to separate the execution decision from the research decision," says Dave Brooks, director of global equity trading at The Boston Company Asset Management (TBCAM). "From a fiduciary standpoint and from our obligation to seek best execution on every trade, CSAs allow us to pursue that goal with fewer conflicts."

According to Brooks, TBCAM has been utilizing CSAs for three and a half years through Westminster Research, an agency brokerage that is now part of BNY ConvergEx. Westminster - which markets Jaywalk, an independent research consultancy - acts as an introducing broker but offers access to a network of 40 executing brokers. Brooks says commission sharing allows TBCAM to execute with the firms or venues that are going to do the best job of trading - whether it's a traditional broker or an electronic agency execution firm. For example, Liquidnet and Pipeline are two venues that are on Westminster's network with which TBCAM "is going to transact whether it gets research credit on those trades or not," he explains.

As a buy-side trader working with a fundamental shop, "I'm trading with certain firms so portfolio managers can get research, which makes it extremely challenging because my first priority is best execution," says Justin Kane, director of trading at Rainier Investment Management in Seattle. Still, Kane and other buy-side traders are taking a wait-and-see approach toward CSA programs. "It's something we're looking into cautiously," he says. Kane explains that he feels there is a need for additional clarification by the SEC, noting that the SEC did solicit comments on commission sharing after it published its guidance in July. The comment period ended Sept. 7.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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