What the institutionalisation of CSAs and outsourced trading tells us about disruption still to come
Tim O’Halloran, Managing Director
Outset Global
The growing use of AI has brought the conversation of creative destruction to the forefront. Last month, the WSJ featured an article titled AI Has Plunged the Book Publishing Industry into Chaos. Certainly, we can expect much of the same in the capital markets. With that, change can be both additive and disruptive, resulting in winners and losers. Where you sit usually dictates how you feel about it.
Today we offer some observations a bit closer to home, in businesses that we know, about how good ideas usually win, despite competitive headwinds and often roadblocks created by the status quo. Good ideas, usually simple ones, always find their way into practice.
In my career, I have witnessed this with a front row seat in two originally niche service businesses that have now become mainstreamed — the use of CSAs and outsourced/supplemental trading. Both simple ideas and both widely accepted.
The CSA Precedent
The use of CSAs, once colloquially known as ‘soft dollar business1,’ was inevitable as sell-side research, independent research and technology, data & analytics became ubiquitous on the buy-side, with investment managers largely seeking to obtain these services via the use of client commissions.
While early on the sell-side fought this change to protect their oligopoly on research and trading, it became clear to everyone (including regulators) that the buy-side would drive the narrative, and the use of CSAs would become standard practice. (This story is much longer and more interesting, but I have capsulized it here for the sake of brevity.)
Today, most major BDs have a CSA presence, many receive CSA payments, and the use of independent research, data and analytics complements the use of sell-side research as a standard practice. How the use of AI will augment, disrupt, or disintermediate this is a question on the minds of many. As the growth of less expensive independent research providers took business from the bulges, will the use of AI disrupt both? As AI is being tested and used in all facets of the business we will soon know.
The Same Pattern, again…
We have seen a similar evolution in the acceptance of both outsourced and supplemental trading. We commented on this earlier this summer in our article titled The Institutionalisation of Outsourced Trading.
With over forty firms providing some form of outsourced trading, the business has become globally accepted. Yet, many still ask if the growth and institutionalisation of outsourced and supplemental trading can lead to a disintermediation of sell-side order flow and/or revenue.
At Outset Global, we know it does not — if you are positioned in a buy-side capacity and if you represent your clients into the sell-side. These are key differentiators. Being independent and being positioned as a buy-side trading desk are integral features for developing a mutually beneficial relationship with the sell-side.
Conversely, if you are positioned as a sell-side firm, you simply compete for order flow with your peers on the sell-side.
When structured properly, an independent outsourced trading firm shepherds order flow to the sell-side from institutional clients with whom the sell-side does not interact directly.
Historically, we have highlighted a number of common use cases for how clients engage us. 2 We now see that our unique buy-side positioning is being leveraged in new ways.
Here is one example — many smaller brokers are paid via CSA. Yet, Outset Global is also regularly asked to earmark flow to non-bulge bracket brokers whom our clients seek to remunerate. In most cases, these brokers would prefer to be paid via order flow to support their trading desk, vs a direct CSA wire. The sell-side is aware of this, and many have strategically sought us out for this purpose — to increase order flow on their desk.
When we establish a single FIX line to a BD and direct a sizable pool of trading flow from a broad swath of smaller institutional clients, we create efficiencies for both the broker and our mutual clients.
This begs the question — if this trend continues will the use of an outsourced trading firm disintermediate the use of CSAs to pay smaller brokers? 3 It is certainly a trend of which we are taking note.
With the advent of AI and other emerging technologies coupled with the buy-side’s interest in saving time and money, we expect to see more creativity around how both the buy- and sell-side leverage their existing resources. U.S. capital market participants have always been innovative and resilient in their pursuit of greater efficiencies.
We also note that in many cases a product or service that may appear to be disruptive or disintermediating may be seamlessly adopted. Yet sometimes new ideas can upset the apple cart. In many cases it is a mix.
Consider how online retail brokerage was once seen as a threat to the “thundering herd” of retail brokers. Expert networks raised similar concerns about the future of traditional sell-side research, while electronic trading and block-crossing technologies prompted fears that cash and block trading would decline or disappear.
What we do know is that these innovations forced change to existing practices yet did not destroy the underlying function. And, more importantly, they were inevitable.
Change always disrupts the status quo and creates a measure of agita for those unwilling to adapt. This has been the case since the dawn of time in every industry. We don’t expect it to be different this time. The growth and adoption of AI will test many, and again, there will be winners and losers.
To quote Ayn Rand, “You can avoid reality, but you cannot avoid the consequences of avoiding reality.” Put another way, sticking one’s head in the sand is not a business model.
We are excited to navigate the meaningful change coming to our industry and look forward to working with our clients, brokers, and other stakeholders, while we adapt to what the future may bring.
As always, we welcome your thoughts, feedback, and suggestions. Please reach out to us at info@outsetglobal.com.
1 The term ‘soft dollars’ was officially retired with the SEC’s 2006 Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act (Release No. 34-54165) as the SEC ‘replaced the term with “client commission arrangements” to “minimize confusion” with the United Kingdom’s term “commission-sharing arrangements”. Today the umbrella term that is most often used is “CSAs.”
2 Common use cases include expanding reach to liquidity, market color, and research, trading offshore markets, adding bandwidth, seeking anonymity, leveraging expertise in derivatives, private placements, and advanced trading tools, trading small caps and closely held names, BCP, etc.
3 We have previously pointed out that many BDs prefer not to establish direct trading relationships with clients who pay them a de minimis amount or who do not meet their revenue and/or profitability hurdles. Conversely, the buy-side has been reducing their BD lists over time to minimize compliance and administrative costs and be pertinent with a smaller counterparty list. This disconnect has created an opportunity.