Harvey Okin
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PDF Help Recent developments indicate that dramatic changes are on
the way for institutional brokers over the next three to five years. New
trading technologies and disclosure rules, the rise of in-house research
capabilities and the resulting decline in per-share commission rates signal an
industry in the early stages of flux. These developments have begun
jeopardizing the source of institutional brokerages' value proposition,
indicating that brokerages must begin now to monitor such changes, determine
how their organizations will be affected and formulate the most appropriate
response to serve clients in the new and more challenging environment to come.
Effects on Brokers' Traditional Services:
Research, not Execution, is What Counts At their core, institutional brokerages provide just two
basic services to their institutional asset manager clients: research and trade
execution capabilities. A Reuters survey conducted by Tempest shows that asset
managers place far greater importance on research in selecting and compensating
their brokers, assigning more than 80 percent of commission dollars for
analysts' calls and visits, research and support services. Especially critical
is research analysts' ability to respond quickly to breaking news to evaluate
its impact on the performance of current and planned investment strategies.
Only 20 percent of commissions is assigned based on the ability to execute
trades, and, in fact, most asset manager view trade flow simply as compensation
for good research.
Closer examination of the 20 percent assigned for trade
execution reveals only four distinct points of value brokers provide:
- Anonymity, which shields asset managers'
intentions from the market.
- Order working, either by finding a
natural match for a large order or executing multiple smaller orders.
- Price improvement, with brokers
executing trades at the best possible price, ideally beating the volume
weighted averaged price for the day.
- Liquidity and market making, by rapidly
finding a ready counterparty or by acting as the principal and accepting the
market risk.
When all four of these points of value are fully replaced by
technology, connectivity and order routing, the traditional role of the
institutional broker will end.
Recent Changes Weakening Brokers' Value These traditional points of value for both research and
execution already have begun to weaken in the face of several recent changes.
The U.S. Securities and Exchange Commission' s ban on selective disclosure, for
example, will narrow the relative information and analytic advantage brokers
have enjoyed over asset managers. Also, the growth of the Internet has made
tools and data such as analyst recommendations, estimates and first call
revisions, news feeds, charts, trading oscillators, market forecasts and
insider trading available instantly online. Once the exclusive province of
leading-edge institutional traders, these tools now are readily accessible by
asset managers and even small retail investors.
In addition, the rise of electronic communication networks
(ECNs) is giving everyone from asset managers to retail investors the ability
to control order routing. ECNs' growing sophistication increasingly will allow
asset managers to bypass brokers and permit buyers and sellers to interact
directly. This trading channel will become even more attractive as ECNs
integrate with asset managers'in-house order management systems, using standard
industry formats to enable seamless order flow directly to and from portfolio
managers' in-house.
As technology improves and players throughout the financial
markets become more electronically integrated, manual execution will wane and
the percent of trading volume conducted directly between institutions will
continue to increase dramatically.
This shift will be driven primarily by asset managers'
fiduciary responsibility to reduce costs as well as their desire to reduce
execution errors, minimize spreads and create seamless flow. The pressure for
cost savings through automation will be greatest for unmanaged funds
historically one of the best performing classes because their research needs
are minimal and trading expenses and related costs often are the largest drags
on fund performance.
Creating a New Future Institutional asset managers will have greater access to
faster and cheaper online functionality as trading technology becomes more and
more sophisticated and widespread. As a result, compensation for research and
advice will become unbundled from trading commission revenue, leaving brokers
even less able to deliver value in the remaining trade execution area. To
offset the continuing erosion of trading-based margin streams, institutional
brokerages must find ways to make themselves integral to the new trade flow by
adding value to it.
For example, brokerages could partner with one or more
leading technology providers to offer market-making capabilities for extended
trade matching and routing solutions. This approach would allow brokerages to
provide liquidity for large orders and generate revenue through commissions,
spreads and return on risk capital.
Another response is focusing on a specific institutional
segment. One example is "the human factor" segment, clients who prefer direct
human market interaction either because they do not believe an automated system
can ever achieve the execution prowess of a savvy trader or because they simply
prefer "the thrill of the game."
What to do Next Technology-driven changes will pose increasingly serious
challenges to institutional brokerages over the next few years. Here are some
steps you can take now to prepare:
- Start monitoring for early indicators that
significant change is imminent. Among the areas to concentrate on
are shifts in strategy or major technology acquisitions by competitors,
per-share commissions, relative ECN trading volumes and trends in direct trades
between institutions.
- Evaluate your clients' needs and preferences
regarding technology and the human factor. At what point might they
consider replacing human market interaction with automation?
- Create one or more visions for how new technology
will create trading interconnectivity among asset managers, institutional
brokers, vendors, ECNs, exchanges and other industry players.
Consider how best to position your organization within these visions and which
players might be potential candidates for alliances or acquisitions.
- Begin formulating a strategy that will allow your
organization to adapt to the new trading environment and succeed under its new
rules.
By starting to address these issues now, institutional
brokerages can equip themselves to provide value by meeting their clients'
evolving needs. More important, early preparation will enable brokerages to
respond in ways that make them integral to the industry's new trade flow.
Harvey Okin, senior manager Strategy & Business
Architecture, Financial Services Capital Markets, where he focuses on business
and information technology strategies. Formerly, he was a vice president at
Morgan Stanley responsible for worldwide IT project management. He is based in
New York City, New York, U.S.
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