The seismic events around the demise of Lehman Brothers just over a year ago shook the foundations of the perceived market norms and made them look decidedly unstable. As a result, investment firms have been forced to quickly reshape and rebuild their processes in many areas. It’s worth taking time to evaluate how the market has changed the dynamics of commission sharing agreements.
In recent discussions with hedge funds, one key area for change is the handling of commission sharing agreements (CSAs). Whilst the handling of research commission pools may not have had the drama of plunging stock prices, the losses that particularly European funds suffered from Lehman were both real and material. So fund managers understand the significant benefits of CSAs, but have concerns as to whether solutions can be found for the following issues:
• reducing counterparty risk from holding pools at a single prime or aggregating broker
• managing the complexity of the various elements of commission management;
• avoiding information leakage through CSA payments about research patterns;
• adding more objectivity and granularity to the broker review.
In this article we examine pragmatic ways of allowing firms to retain the benefits of these types of arrangements, but also to efficiently mitigate and manage the risks involved.
Reducing counterparty risk
The Lehman bankruptcy identified a major weakness in dealing with a single broker: it opens fund managers up to considerable counterparty risk. The key to avoiding this risk exposure is through diversification. Where once investment managers were reducing the number of CSA brokers, even down to a single aggregator, they now need to reduce their dependency on individual brokers. However, without adequate operational support, this reduction in credit risk can come at the price of a significant increase in operational risk.
An alternative response being used by some firms is virtual aggregation where firms can maintain a single virtual pool in one place, but independent of any single broker, as the firm uses multiple broker pools. If correctly implemented, this approach has the benefits of the single broker aggregator model, including easier operation, but avoids most of the credit risk issues.
Another important element in the credit risk solution is to pay down research commission balances more often, at least quarterly. It also virtually mandates quarterly broker votes to provide justification for the distribution and adds further weight to the need for an integrated, systematic solution.
From our client experience, many investment firms do not view the full commission management workflow as a single integrated process. Instead you may have a broker voting process in one system, target setting in a spreadsheet, actual commission tracking in your settlement function, CSA agreement handling in legal and compliance, CSA invoice tracking in finance and broker review in the front office. Whilst at first sight this may seem the simplest or indeed most practical approach, it makes the risk greater due to the larger numbers of interfaces, and the manual and spreadsheet-centric processes involved. For example, the typical solution seen in many institutions is to rely on the flexibility of spreadsheets and the ingenuity of one member of staff in each department, who has a detailed knowledge of all the rules, quirks, bells and whistles, which despite your best efforts can creep into these agreements.
This manually intensive spreadsheet approach can work well for low volume, relatively simple constructs. However, it is reactive, subject to individual knowledge and firms cannot easily evaluate whether they are making best use of their commission pool. Any system also needs to accommodate variations in terms of the type of commission provided. For example, it should be robust enough to identify trades in the front office, which are relevant for the CSA versus principal trades that are not, for example. It also needs to identify which commission split rates apply, typically these can vary by market, counterparty, trade type etc.
An increase in numbers of agreements and frequency of pay downs can add significant stress into a disjointed process. To make the emerging model work, technology in the form of workflow can help unify information and avoid costly errors.
Information leakage through CSA payments is another concern for funds. A stream of regular payment requests to brokers for other brokers and research providers from investment firms gives out valuable information. Without complex mixing and masking of payment requests, brokers may well be able to understand which other research providers are being used by which investment firms from the payment stream. This information could allow brokers to compete against other research providers. What is needed is a way of randomising payment requests to mask the regular or large recipients of research payments. Some firms have attempted to do this in the same manual, spreadsheet-based way and have found that it consumes significant management time once a month or once a quarter. This approach is not for the faint-hearted. However, the right technology can simplify this entire process.
Enhanced broker review
During the bull markets, many investment firms were less cost conscious about research and services. Now in these more cost constrained times, brokers and funds share a common cause to understand which broker research and services are most valued. Simplistic broker voting and broker review processes may not give this level of granularity. We are seeing more demand from hedge funds to identify the specific items, such as conferences, meetings, one to ones, and models that each broker provides in a pragmatic way, so this can be fed into this process. It is in a broker’s interest to provide this to the investment firm in support of their appraisal of providers. It is also useful for the fund manager for a number of purposes, not least in explaining to an errant broker where they are falling down against their competition. It can make the broker review process more objective. To do this effectively needs some form of centralised mechanism to allow sharing of this information on broker interactions.
Hence with smart business thinking moving towards a more sophisticated and diversified CSA model, using an informal, manual and spreadsheet procedure to support it is no longer a viable approach. As volumes and complexities grow, an integrated central application is required. This is where purpose built software comes into play. The right technological solution can tame complex financial processes and workflow. Lastly, whatever technology is to be used, the first task is to acknowledge there is an issue, and get beyond the assumption of simplicity by mapping out the multiple paths, processes and people involved and fully understand the business process. As Einstein might say, it is time for a new way of thinking to get us to where we want to be.
John Cant is Managing Director of MPI Europe. He has more than 20 years of experience within the financial services, management consultancy and technology sectors. Prior to founding MPI Europe, he was a Managing Director of ATOS KPMG Consulting, having also been a Partner at KPMG.