Brokers are undergoing a “Darwinian evolution” as a result of demands from their buy-side clients and their own internal challenges stemming from the global financial crisis, according to a new report from Celent, a research and advisory firm.
The report, ‘Capital Markets 2.0: The Future of Institutional Brokerage and Market Making Operations’, found that broker-dealer revenues fell 39% in 2008 compared with 2007, and that bets in the sub-prime and fixed income, currencies and commodities markets accounted for 20% of the overall decline.
At the same time, the buy-side has become more demanding. The report notes that unprecedented levels of volatility have challenged many buy-side models and choice of algorithmic trading tools. As a result, buy-side traders are now requesting more customised, easily integrated and flexible tools to navigate the changing environment.
The report notes that as well as facing financial troubles and growing demands from their buy-side clients, brokers are facing competition from all sides. Technology vendors and exchanges are both moving in on brokers’ turf. Celent predicts that independent execution management system (EMS) providers such as Portware and FlexTrade will increase their share of buy-side desktops as broker-owned EMSs become less important and less likely to receive research and development funding.
Meanwhile, exchanges and alternative trading platforms are starting to offer some basic trading services, such as order routing, simple execution algorithms and crossing services.
Celent says that agency brokers and those that employ relatively agnostic approaches to the sources and direction of order flow will benefit from the increasing shift of power to the buy-side, increased concerns about counterparty risk and capital limitations.
“Execution firms with a relative lack of broker-neutrality due to a proprietary EMS like Goldman Sachs’ RediPlus and Morgan Stanley’s Passport might be slightly disadvantaged due to client demand for maximum flexibility and connectivity options, along with their own concepts of best execution,” the report said. “To deal with these disadvantages (real or perceived), we believe all brokerages, of not already, should ‘neutralise’ and open up their execution models as much as possible.”
The report acknowledged that brokers are starting to cooperate more and forge partnerships. One example is the links some brokers have established between their internal dark pools, such as that announced between Morgan Stanley’s MS Pool, Goldman Sachs’ Sigma and UBS’ PIN in the US last year.
“While still required to provide leading edge services, partnering with competing brokerages is an important strategy to sustain client flow, particularly for the full service firms,” the report said. “For those in the business of providing best execution, liquidity is a huge selling point and linking alternative trading systems, non-displayed pools, or non-broker venues like ECNs/exchanges are essential strategies in maximising the matching rate for clients.”
Given this trend, Celent envisages a world where brokers increasingly work together to respond to client demands. “Increasingly, rather than build, brokers will partner with each other to access new markets, connect to new venues, and allow trading flow to be matched among selected parties,” the report said. “A new spirit of cooperation will result from the lack of capital and desire to preserve relationships for the long run.”