A revolution in broker business models

It probably doesn’t come as any surprise to find that brokers are being forced to change their business models to cope with the new normal of highly regulated and increasingly automated trading in all asset classes.

In recent weeks, The TRADE has been speaking to brokers and others in the industry to get a handle on what these changes really mean for the brokerage business and what impact it might have on the buy-side.

Of course regulation was a big topic in our discussions, though I found it interesting that most of the change was not simply due to direct regulatory change, but was focused on the client.

The way buy-siders trade has been transformed in the five years since Lehman Brothers spectacularly exploded and at least some of the brokers we spoke to recognised that this is what is ultimately driving changes to their business.

ITG’s CEO of EMEA, Rob Boardman, told me that the demands of his clients have evolved and this means that ITG itself has got to make sure its model evolves alongside it.

Multi-asset dealing was one of the major changes being driven in part by regulation, but also due to economics. As markets become more automated, many asset managers have realised that their equity traders have built up significant expertise in making the most of automation.

The result is merged trading desks covering multiple asset classes; where everyone is expected to trade in equities, FX, derivatives and fixed income.

Higher costs of doing business are also changing buy-siders and causing them to take advantage of scale, with Boardman predicting the rise of “super buy-side” firms with US$1 trillion or more in assets under management. While most brokers operate on the so-called 80-20 rule, where 80% of their revenues come from 20% of their clients, the emergence of the super buy-side could result in a 90-10 rule, amplifying the importance of keeping the biggest clients happy.

Boardman was optimistic that the future favours the agency model (not that surprising since he runs an agency brokerage), and this view was shared by industry veteran Richard Balarkas.

As regulation puts pressure on trading done off-exchange to move on-exchange, investors are becoming price makers rather than price takers, and the broker is becoming more like an agent.

Balarkas noted that most of the large investment banks have already been positioning their equity business as agency brokerages, but foresees this affecting other asset classes such as fixed income and OTC derivatives.

But there are questions surrounding whether or not this model will deliver the return on investment that banks need given the level of risk it carries. Banks are also conflicted by not wanting to exit the market because the barriers to re-entering might be too high.

The feeling from the industry is that it’s tough to be a broker right now and it’s only going to get tougher. While this might paint a depressing picture, for the buy-side this means the balance of power is shifting in their favour and the need for their brokers to retain their business means they should look forward to increased levels of service and brokers that really work for their interests in the future.