01 May
In response to new post-MiFID II regulatory freedoms in the UK and the EU, many asset managers are deciding whether to take advantage of the opportunity to return to CSA-funded research budgets in Europe. As confidence increases that this will be a wider industry trend, several asset managers will have transitioned to the new “joint payments” model by the end of the year, aligning their processes with industry practice in the US and Asia, albeit with some additional guardrails from the FCA and the EU regulators.
In addition to those asset managers who are already proceeding with the move to CSAs in Europe, a wider group are making operational and disclosure-based preparations so that they can be ready to move when the timing is right for them. A large group of firms are therefore working through their IMAs, checking clauses and commitments regarding research funding and looking at their operational processes and systems. They are also analysing how many CSA brokers they will want to work with, which brokers they would choose and whether they will use the services of a CSA aggregator to manage the overall process. And as they do so, the theme of creditworthiness and counterparty risk has become a greater focus against the backdrop of volatile and unpredictable market conditions.
In recent years, key market participants and regulatory authorities have expressed significant concerns regarding the credit risk posed by broker counterparties. The Basel Committee on Banking Supervision released final guidelines for Counterparty Credit Risk (CCR) management on December 11, 2024. These guidelines advocate for rigorous due diligence during both the onboarding process and ongoing relationships, the development of robust credit risk mitigation strategies, and the implementation of diverse metrics to measure and control CCR. The guidelines aim to rectify longstanding weaknesses in CCR management practices within the industry.
Financial institutions are being urged to adopt more stringent risk assessment frameworks, enhance due diligence processes, and improve transparency to mitigate the risks associated with their broker counterparties, which will include the CSA broker list. Creditworthiness is also proving to be an important factor when selecting a CSA aggregator. While aggregators are primarily service providers that manage and streamline the relationships and transactions between asset managers and multiple brokers, their financial stability also remains crucial.
Asset managers looking to move to a joint payments model in Europe are focusing on several areas when it comes to their approach to CSA brokers and aggregators:
1. Risk of Default or Non-Payment
Under a CSA, the executing broker receives the full commission on trades and then allocates a portion of it to other brokers, research providers, or to custodial aggregators. If the executing broker becomes insolvent or experiences financial distress, they may fail to pass on the allocated research payments. This equally applies to a situation where a custodial aggregator is selected to sweep and hold CSA balances. In both cases this could:
- Create regulatory issues: in their policy statement (PS24/9) released in August, the FCA outlined that firms adopting Joint Payments are ‘fully responsible for… ensuring timely payments to research providers’.
- Disrupt access to research: The asset manager might lose access to crucial research if payments to third parties are not made.
- Create legal and financial complications: The manager may need to deal with legal claims or disputes if payments are withheld due to the broker’s financial instability.
- Expose client funded CSA balances to counterparty risk: Although CSA payments are not direct client assets, poor creditworthiness of the broker could create broader operational and financial risks.
- Expose the firm to unforeseen P&L costs as they have to step in to make direct payments to their research providers that would have otherwise been made by the CSA broker.
2. Operational Reliability
It’s clear that financially stable brokers will have the resources to invest in more robust operational controls than those which may be less financially secure. Similarly, a financially sound, creditworthy CSA aggregator is better positioned to maintain rigorous systems, ensure accurate tracking of commission flows, and handle disputes or errors promptly. But what are the specific operational risks?
If the broker or aggregator encounters financial difficulties, it could lead to:
- Service disruptions: Interruptions in the aggregation or processing of CSA payments.
- System failures: Delays or errors in payment reconciliation which might complicate the distribution of research payments. These could result in:
- Misallocated or delayed payments, potentially putting the asset manager in breach of FCA guidelines regarding the timeliness of research payments.
- Record-keeping issues that make it harder to verify payment accuracy.
3. Creditworthiness as a Signal of Stability
- A broker’s financial health is a signal of their operational stability and longevity. Choosing a creditworthy broker reduces the risk of disruption in the CSA payment process and ensures continuity of research relationships.
- Whilst an aggregator is not directly holding client assets, its role as an intermediary makes its stability critical. The aggregator’s ability to settle transactions efficiently relies on its own liquidity and credit profile.
Tying it together – Regulatory and Fiduciary Responsibility
Asset managers have a fiduciary duty to act in the best interests of their clients, and this includes ensuring that brokers and aggregators handling client commissions are financially stable. Failing to consider counterparty risk could expose clients to unnecessary risk, which will raise compliance and regulatory concerns. A stable, creditworthy aggregator reinforces confidence in the overall commission-sharing infrastructure and reduces the likelihood of issues that could compromise research payments.
What should asset managers keep in mind as they explore their options?
When planning the move to joint payments in Europe, due diligence on brokers will naturally be essential before entering into CSAs, including reviewing financial statements, credit ratings, and regulatory history. And even after entering into a CSA, as with any counterparty, it’s important to regularly assess financial stability and creditworthiness.
While CSA aggregators serve as facilitators rather than direct custodians of client funds, their creditworthiness is a critical component of a well-managed CSA framework. Financial stability ensures they can perform their role reliably, minimize operational disruptions, and uphold the integrity of the commission sharing process — all of which are essential for safeguarding client interests and maintaining the overall health of the investment research ecosystem.
The pace and breadth of adoption of joint payments in Europe is still unpredictable, but however it unfolds, robust management and understanding of counterparty risk will underpin its success for the buy side.
