According to a releases of the results of Greenwich Associates’ 2008 U.S. Equity Research, more than 45% of institutions say they employ CSAs—up from the approximately 25% of institutions that reported using CSAs last year. Another 5% of institutions say they plan to establish a CSA over the next 12 months. Traditional soft dollar arrangements were used by more than 60% of U.S. institutions as recently as last year.
Overall, U.S. institutions are directing an estimated 16% of total U.S. equity trading commissions via CSAs, and expect that to increase to 20% over the next 12 months. Among active users of CSAs, the share of commissions allocated through the arrangements grew to 23% this year and is expected to rise to 27% in 2009, the release said.
Who’s Getting Paid?
Greenwich Associates said about half the commissions paid by institutions via CSAs are retained by the executing broker, with the remainder passed along to third-party research providers. Typically, institutions say executing brokers retain about 30% of CSA commissions as compensation for execution services, and slightly more than 20% as payment for proprietary research.
Based on research in the European equity markets, Greenwich said this U.S. commission split is unlikely to persist. Across Europe, executing brokers retain nearly 60% of CSA commissions, including about 35% for execution and a quarter for proprietary research.
“Having watched the evolution of the CSA structure in Europe, we strongly suspect that the U.S. market will develop in similar fashion,” said Greenwich Associates Consultant Jay Bennett, in the release. “In our opinion, it is highly unlikely that executing brokers in the U.S. will continue to pass along half of CSA commissions to third-party providers.”
A New Competition
The rapid development and adoption of CSAs in the United States is beginning to have an impact on the competition among brokers for institutional investors’ U.S. equity trading business.
Greenwich said the firms named most often by institutional investors as important CSA brokers are Merrill Lynch and Lehman Brothers, which also rank as the top two brokers in the U.S. overall in terms of total institutional market penetration.
However, the research results do not indicate that the proliferation of CSAs deals a painful blow to small and regional brokers. “There is a general assumption in the market that the bulge bracket brokers will eventually dominate the role of executing broker and capture a big portion of these concentrated commission flows due to their ability to distinguish themselves on the basis of best execution,” said John Feng, managing director, in the press release. “But it is interesting to note that at the present moment, firms like Instinet, BNY Converg Ex and ITG are not only quite competitive in terms of quality, they are outperforming many of the biggest U.S. equity brokerage houses.”
According to the Greenwich data, institutions using commission management arrangements said they have stopped trading with between 18 and 19 firms that now get paid for their research via CSAs.
The bad news: Brokers who find themselves relegated from a trading relationship to the status of CSA commission recipient will not necessarily find the transition a profitable one, as brokers earn more money executing trades and retaining some or all research commissions for their own proprietary products and services than they do when they receive a check for their research.
In addition, the CSA payment process can cause cash flow problems for brokers, because they generally get paid quarterly rather than at the time of the trade.