Mar 27, 2012
New levels of transparency
While the cost pressures on banks
and brokers are well-established, institutional investors are tackling
budgeting challenges no less steep for their lower profile. In many cases, it is trading desks that are
bearing the brunt of the problem and working hardest to extend best execution
to procurement of sell-side services.
John Meserve, head of technology provider ConvergEx Group’s commission management
business, says the buy-side has become
an increasingly careful purchaser. “Pressure on commission wallets have made
this issue front and centre for many money managers. Transparency and
disclosure are key themes,” he says.
The scale of the cutbacks
being implemented by brokers remains staggering. A new report by Morgan Stanley
and Oliver Wyman predicts that investment banks will shrink their balance
sheets by US$1 trillion over the next two years, while also eliminating
US$10-12 billion by slashing wage bills and other overheads. Nor is the
buy-side immune from the post-crisis readjustment, with pressures on fees and
increased regulatory costs squeezing once-robust business models. While 74% of
clients recently polled by investment management consultancy Investit cited
‘regulation, risk and compliance’ as their highest priority for the coming
year, on the trading desk, the focus is on making less money go further.
Earlier this year, TABB Group
confirmed the long-term slump in commissions paid by US investment institutions
to their brokerage counterparts. The research consultancy’s annual survey, ‘US
Institutional Equities: State of the Industry 2012’, predicted that commissions
would register a third consecutive fall by the end of the year. The response of
buy-side trading desks to continued low trading volumes and therefore
commissions has been to ensure that they only pay for what they need from the
vast array of available sell-side suppliers and services.
“Brokers are
having to make some tough decisions about cost structures, but institutional
investors are facing a lot of the same issues. In this low-volume environment,
buy-side firms are trying to figure out how to pay for all the sell-side
services they require. On the one hand, they need to be more transparent about
what they value, on the other, we need to be transparent about our charges,”
says Bill Bell, head of electronic
distribution, Americas, Barclays Capital.
All you can eat
It’s hard to cut back,
however, when you’re only vaguely aware of the cost. Portfolio managers and
analysts consume research and accept meetings arranged by brokers, but they are
rarely if ever confronted with the bill. Typically, they leave the buffet
before it arrives, leaving the trading desk to figure out how to pay from
diminishing flow.
While the concept of best execution
is well entrenched on the trading desks of most buy-side firms trading in the
US markets, the same attention to value for money is only now taking root in on
the research side. The prospect of hedge fund registration under Dodd Frank has
raised the profile of research payments. “How they spend money with brokers –
what is a good investment idea worth or how much value does a one-on-one
meeting bring – is being more heavily scrutinised,” says Meserve.
Increasingly, greater use of
technology is creating more transparency on what the buy-side values, by making
broker votes more process-driven and auditable, and more sophisticated use of
commission-sharing agreements (CSAs) are providing more options for paying for those
services.
"Both commission compression
and a greater need to be able to explain broker payments are driving use
of technology to increase transparency," notes Jonathan Kellner, president
of Instinet Americas.
Instinet’s Plazma
broker-neutral, multi-asset commission management suite introduced broker
voting capabilities last November that allow PMs to add relevant information
about different brokers throughout the review period. Such tools try to make a
hitherto manual and burdensome activity more robust and automated, while
retaining sufficient flexibility to accurately reflect the value of different
types of service to multiple participants, who may be spread around the globe.
While you may never see a
price tag on a piece of broker research, the increased rigour of broker votes has
the same ultimate effect, according to Meserve. “They are literally voting on the
value they get from research and one-on-one meetings,” he says. ConvergEx has
extended the broker voting capabilities it acquired via the purchase of Cogent Consulting
in 2009 and now its platform handles input from around 600 sell-side firms.
Spread too thin
Inevitably in an over-supplied
market, the first priority for the budget-constrained buy-side is consolidation
of business with a smaller number of brokers. Clients still put a high value on
corporate access, so it becomes a matter of working out how to pay for those
events and services. A buy-side firm might have 130 brokers, of which 10-15
might be considered strategic partners, through which most orders flow. As such
it makes sense to simply cut a cheque for the broker that organises a highly
valued conference on, say, Mid-West mid-caps, rather than spread trading
commissions too thin. A well-planned CSA structure enables buy-side
institutions to pursue best execution from a trading perspective, without
hampering access to the content the PMs most value.
A growth in use of
CSAs can lead to greater administration for the buy-side trading desk if
managed in-house. Traditional aggregation services from the sell-side were
sometimes viewed with suspicion – on grounds that client funds were not always
scrupulously isolated – especially when many third-party brokers went unpaid
for months after the collapse of Lehman Brothers. But institutional investors are
now turning to a crop of web-supported commission aggregation tools that help
them centralise and direct payments to brokers. A number of agency brokers,
including ConvergEx and Instinet, offer programmes that consolidate credits
from multiple execution brokers. In
October 2011, financial information firm Markit launched its Commission Manager
service specifically to address buy-side concerns about maintaining commission
credits with a single institution. Developed in partnership with Bank of America
Merrill Lynch, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman
Sachs, J.P. Morgan and Morgan Stanley, it is designed to reconcile trading
commissions with multiple counterparties and instruct payments via a single
neutral platform.
"The buy-side is
generally more comfortable with CSA aggregation through a single broker now
that web-based portals are able to offer greater balance transparency and
protection," says Instinet’s Kellner.
ConvergEx’s Meserve notes an
increase in requests for proposal for CSA aggregation services over the last
six-to-nine months. “Money managers are looking for help to industrialise their
processes as much as possible. They get paid to generate returns for investors,
not run back offices,” he says.
Healthy exercise
For some, a suitable response
to low trading activity is to pay ‘over the odds’ to guarantee supplier
attention. Bell identifies an
increase in high-touch trading as one symptom of the buy-side’s current situation,
noting that high-touch flow has recently increased to account for more than 50%
of client orders. To maintain commissions at a level that will fairly
compensate a particular broker for the amount of content their PMs and analysts
consume, buy-side trading desks can either choose high-touch execution channels
more often or pay more to trade via algorithms. “In the past three to four
months, not only has the question of commission compression disappeared, we’ve
seen commissions first stabilise then increase. Clients are still trading
electronically, but they are looking to pay higher commissions to do so,” he
says.
Bell emphasises
that the sell-side also needs to organise itself better to help money managers
become more effective consumers. He points out that Barclays Capital’s equities
division now operates a ‘flow aggregation group’ that covers all agency flow,
across its electronic trading, domestic and international portfolio trading,
and corporate buy-back businesses, plus commission management and market
structure. “We are constantly advising clients on the smartest way to structure
a CSA / CCA and the best way to execute it in the market conditions,” say Bell.
“This might include advice on getting the right balance between high and low
touch, relative commission levels, how many brokers to pay, how many checks to
cut and what to pay for.”
In the long run, says
Bell, this will be a healthy exercise for both sides. “This level of
transparent conversations between both parties will be very fruitful once we
come out of this volume environment,” he says.
Chris Hall
+44 (0)20 7397 3819
chris.hall@thetrade.ltd.uk