Equity trading has matured. It did so a decade ago when technology became indispensable. Trading is now more rigorous. The buy side became empowered, algorithm use exploded, and the use of direct market access mushroomed. Brokers have struggled to keep their offerings competitive and their operations afloat in an environment in which trading commissions have steadily declined and margins have become razor thin.
Brokers were their own worst enemies in this evolution. Instead of embracing change and understanding how it would impact their business, they fell victim to it. Failing to employ decisive strategic initiatives appropriate for market conditions, they instead engaged reflexively in hyper-intensive price competition. This had two unintended and entirely negative results: it drove down margins in equity-related businesses; and it broadcast the perception that execution services were merely a commodity, reducing their value in customers' eyes.
Today, top buy-side clients enjoy commission rates south of 50 mil-per-share in addition to virtually free technology, execution consulting, technology consulting, and trading analytics. Brokers are far from the profit centers they once were and market conditions are more complex than ever.
Can brokers recover, or will industry maturity lead to decline and elimination of the financially weakest providers?
We believe that, short of an industry-changing breakthrough in trading services, some recovery can be achieved. This will require enlightened management willing to think "outside the box" and make hard choices. Brokers must take steps that will give them the best chance to maximize profitability. Put simply, that boils down to one of three general strategic directions:
1) Low-Cost leadership
2) Differentiation; or
3) Focus on a particular segment of the buy-side and combine low cost with differentiation.
Execution services should not be treated as a commodity -- valuable differences exist among broker offerings. Some can bring significant value: for example, the effective handling of "high touch" orders and measurable algorithm performance. The complexities of present-day markets require brokers to perform more work than ever before across a broader scope of activities. It isn't just sales anymore. Brokers now perform substantial consultative work with the buy-side, market structure analysis, analytics, technology, and operational refinements. Under usual circumstances these customized services would easily justify an increase in pricing -- but today's market does not bear it.
Quite frankly, brokers have failed terribly in their overall strategic approach to our mature equity markets. The reasons are varied, but for the most part firm management during the period of buy-side trading empowerment, ECN use, and algorithm proliferation a decade ago:
- Refused to acknowledge market evolution;- Was unfamiliar with the strategic responses needed to address a maturing industry; or - Lacked the focus or skills to act in an era of unprecedented change.
Still, in other instances, brokers lacked or undervalued the tools, infrastructure and personnel to strategically analyze the markets and position their firms accordingly.
How should brokers react to increasing automation, market fragmentation and plunging commission rates? We discuss some general strategic approaches below that we believe could significantly improve brokers' competitive positions in present day markets.
Strategic Initiatives and Mature Markets
Strategic prerogatives are substantially more important during the maturity phase of an industry or business than during the growth phase. While an industry or market is growing, raw demand for services and other pure economic drivers can mask sub-standard or flawed strategic initiatives. Firms can prosper despite weak business strategies. This is not the case in mature industries or businesses, where demand for services is limited or flat.
In a business where services are perceived as near commodities, mature business conditions often result in intense price and service competition. This is precisely what occurred in the equity markets at the turn of the 21st Century, with buy-side trading empowerment and electronic trading. And it continues today.
Businesses in mature markets generally have three strategic choices:
Low Cost Leadership: The low-cost leader cuts prices to the bone but has the organization, infrastructure, and finances to operate effectively at extremely thin margins. The intention is to compensate for thin margins with higher business volumes. This has applicability in the equity markets but may be confounded to a degree by certain industry-specific issues like the bundling of research with execution services.
Comparatively few brokers have the size, scope and infrastructure to potentially succeed as low-cost execution service providers. Candidates would likely come from the ranks of the global, full-service brokers who have broadly developed global infrastructure and substantial financial resources. Those choosing this strategy would have to maintain the proper mix of resources suitable to draw substantial, low-touch order flow.
We would expect such firms to have substantial technology platforms and considerable financial resources necessary to weather a transition from across-the-board cuts in commission rates to an uptick in share volumes. We would also expect these firms would have to make significant organizational, staffing, infrastructure and technology modifications. They would provide comparatively "no frills" basic execution services to buy-side firms that value low explicit commission rates and basic benchmark strategies. In our view these firms will offer simplistic algorithms that require less intensive modification and smaller quantitative staffs, but more robust technology personnel to maintain systems, connectivity and related infrastructure.
Differentiation: Firms seeking to differentiate their offerings do so with the expectation of receiving greater remuneration for particular added value.
Brokers choosing to differentiate would have to intensively modify many aspects of their service offerings. This will require organization, staffing, infrastructure and technology resources in line with greater specialization.
At a high level, management and staff must possess the skills to understand and oversee complex algorithm and execution services development. Hardware and software must support the greater emphasis on complex analysis and development. Technology must support differences in focus from the low-cost provider such as the processing, handling and back-testing of more extensive data sets. Sales and marketing organization, approach, and staffing would differ from those of the low-cost providers. There are other differences but these are the main points.
Many reading this piece might believe that brokers have been actively attempting to differentiate their services for years. We agree. Yet communicating this has been done quite ineffectively – mostly through quasi academic studies by in-house quantitative or academic studies, often rife with assumptions and biases that promote the report's provider. The buy-side audience either doesn't care, doesn't have the time or focus to understand the merits of the offering; or the complexities and delivery of the presentation are beyond that of the audience. Furthermore, the sell-side may be approaching the wrong audience altogether. A different approach is required.
Focused Strategies: Firms pursuing focused strategies mix elements of low-cost and differentiation strategies while targeting a limited market segment.
Some brokers can and should elect to pursue a more focused strategy. These firms could, for example, handle specific types of order flow in particular instances for certain types of buy-side firms. Experienced sell-side traders understand the differences in needs and expectations between the long-only investment fund, the pairs-trading hedge fund and the quantitative trading firm. Tuning offerings to precisely fit the needs of one of these consumers could result in excellent positioning and above-minimum remuneration.
This type of strategy is, in fact, successfully practiced through prime brokerage businesses that provide bundled services to hedge funds.
Management and Change
Management has primary responsibility for the lack of strategic direction. That written, we believe it isn't really their "fault," it's not for a lack of management intelligence, dedication or aggressiveness, even if it is their responsibility to fix.
Most sell-side management is comprised of highly intelligent, capable, driven individuals who have already achieved great success. The skills for which most were hired, and those cultivated through careers in sales and trading, are not those that best facilitate rigorous strategic analysis and business management. These managers are adept at the use of sales-based approaches and related metrics in running their businesses. Most sell-side equity business management can tell you their year-over-year volume growth in the blink of an eye. Finding true business profitability is something else.
Compensation practices have been unfriendly to equity trading businesses. Managers and staff continue to be rewarded on the basis of revenue generation, and not business profitability. This has made it possible for managers to move among firms quite successfully after comparatively short stays at other institutions, even thought their impacts may not have been truly ascertainable.
Strategic and administrative skills gain importance as the success of the business relies more heavily on industry and competitor assessment, cost control, cross-functional coordination. These skill sets are extremely different than those needed during industry growth phases. Most managers within sell-side equity trading groups have resisted acknowledging the need for these skills. For the most part, rigid adherence to historical organization and practice has continued, rarely questioned.
Even in firms where the "business manager" role does exist, the mandate is often less on strategy formulation and more on administrative issues. This includes working with outside vendors, maintaining desk "foot prints", and working with internal development groups to facilitate projects. They often do not hold the position or stature to make meaningful organizational or business changes. Their efforts are almost always seconded to those "generating business."
Trading groups thus cannot develop comprehensive business strategies, understand their own cost structure or assess performance-based metrics such as return on capital. At base they are unable to adequately price their execution services, analytics, technology and related services. This is why brokers are arguably underpaid for low-touch services in the current market, and have been largely unsuccessful in differentiating their offerings.
Rethinking Business Approaches
Conditions in the brokerage industry call for radical thought. Industry capacity cannot support the current number of global "full service" brokers. Furthermore, those who have tried to differentiate their service offerings have done poorly at it. Change must come - who will best adapt?
Brokers pursuing differentiation strategies must reach the right people and communicate the differences in their offerings in clear, convincing ways. Pushing academic-like studies generated by internal staff to buy-side line professionals may be the worst possible approach - traders have their hands full with order flow, plus they are unlikely to have the backgrounds (or interest) to digest such studies. Obvious self-interest on the part of the firms producing such studies doesn't help either.
To implement any strategy, brokers must be able to conduct sophisticated costing. Since they have generally been viewed as support staff, individuals with these skills have been cut from many firms, and skeleton crews often exist in these roles. Nonetheless, sophisticated costing is essential to identify business areas that are being cross-subsidized, help determine the optimal service mix, and price one's services.
Conclusion: Radical Thought
Formulating "the answer" for brokers in mature equity markets is not easy. The scope of sell-side execution services and the needs of the buy-side are extensive. Quality sell-side providers should be able to enhance their positions within the market, and garner better compensation for their services.
The problem is that, as discussed above, brokers have done a poor job devising and implementing the strategies necessary to success in a mature equity market. Brokers must stop competing on price. The sell-side has poorly communicated its messages to the buy-side. The industry tendency to elect management from the ranks of salespeople and traders has tragically undervalued support functions. The results have been unscientific and ineffective strategic decision-making.
Radical thinking is essential if sell-side firms wish play long-term in the equity markets. The directions, strategies and initiatives are highly firm-specific, but failure to take decisive action will keep morale and performance at historic lows.
We do not pretend to have answered all the questions in this piece, but there are things that can be done.
We say kudos to managers who take the lead.
Matt Samelson is principal, director of equities, for Woodbine Associates.