What it means
Large investors such as fund managers buy and sell big blocks of shares. They may prefer one broker to handle the execution, perhaps because that broker is good at finding liquidity, but they may want to pay another broker for research or services.
A step-out allows this: the executing broker completes the trade and then allocates a share of it to the second broker. The second broker then receives its part of the commission, usually through a pre-agreed split.
The investor's trade is still done at one price, and the commission is shared between the two firms. In some markets this is part of what are called soft dollar arrangements, where commissions pay for research as well as for execution.
For the client, the benefit is flexibility. The investor can use the best desk to execute while still supporting the brokers whose analysts or services it values.
For brokers, step-outs help smaller firms with strong research get paid without needing a large trading operation. Regulators pay attention because commission paid for anything other than execution can disadvantage the fund's own investors.
Fund managers have a duty to seek best execution, which means getting the best overall result for the client. They also need to disclose how commissions are used, and in several jurisdictions the rules on paying for research with client commissions have been tightened.
The practical point for finance teams is documentation. Each step-out should be recorded, the split should be agreed in advance and reconciled afterwards, and the totals should be reviewed by compliance.
Without these controls, step-outs can create errors in settlement and difficult questions in an audit.
In practice
Real-world examples.
Example
A pension fund manager wants a large trading desk to buy 250,000 shares of an industrial company without moving the price. After execution, the desk steps out 60% of the trade to a research boutique the fund uses. The fund keeps its relationship with the boutique and the trade is completed quietly, without the price moving against it. Compliance logs the split and the research service it pays for.
Example
A hedge fund's compliance officer reviews the quarter's trading and finds $180,000 of commissions were stepped out to six brokers. She confirms that each had a written agreement and a documented research service. She files the review in case regulators ask about it.
Example
A small research-only firm has no trading desk but its analysis is highly valued by an asset manager. The manager arranges step-outs so that the firm receives commission income. The firm uses the money to employ two more analysts.
Formula
Calculation
Commission to each broker = shares traded x commission rate per share x agreed split
Suppose a fund buys 100,000 shares with a total commission of $0.03 per share, so total commission is 100,000 x 0.03 = $3,000. The agreed split is one-third to the executing broker and two-thirds to the broker stepped out to. The executing broker receives 3,000 x 1/3 = $1,000, and the second broker receives 3,000 x 2/3 = $2,000. The fund pays $3,000 in total, the same as if only one broker had been used.Case study
Seen in the real world.
Brackenridge Capital is an illustrative, fictional fund manager with $2,000,000,000 under management. It used one large broker for most execution but also relied on two specialist research firms.
An internal review found that the commission paid to the research firms was spread unevenly and poorly documented. Some stepped-out trades had no record of which research service they were paying for.
The firm created a written policy requiring each step-out to cite a service, a split and an approval from compliance. Over the next year the paperwork improved and the firm could show clients exactly how their commissions were used. The illustrative lesson is that step-outs are legitimate tools, but only if they are controlled and transparent. Clients later told the firm that the clearer reporting gave them more confidence in how their money was handled.
Watch out
Common mistakes.
- Assuming a step-out increases the total commission paid, when the total is normally the same and it is the split that changes.
- Using step-outs without written agreements, which makes reconciliation and audit very difficult.
- Ignoring best execution duties, when the choice of execution broker must still serve the fund's investors.
Questions
People also ask.
Why would an investor use a step-out instead of paying one broker?
It lets the investor use the broker best suited to execute while still paying other brokers for research or services it values.
Is step-out trading legal?
It is generally permitted when properly disclosed and managed, but rules on commission use differ between jurisdictions and have tightened in some.
Who benefits from a step-out?
The investor gets flexibility, the second broker earns commission and the executing broker keeps its share, but investors should make sure their own costs are not increased.
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