Focusing on what matters

Having faced an adverse trading environment for almost four years, buy-side firms are worried that the current range of services offered by large brokers will soon be unsustainable.

Why is it in the buy-side’s interest to concentrate its flow with fewer brokers? 

There appears to be a growing sense among buy-side firms that their sell-side counterparts need a reality check.

Despite being plagued by an adverse trading environment for the best part of four years, brokers have largely attempted to maintain the broad range of services they offered pre-crisis. This is despite continued downward pressure on the commission pot available to the buy-side, caused by both low equity trading volumes and greater use of electronic trading tools.

Moreover, some buy-side firms, notably Aviva and Scottish Widows Investment Partnership, have switched from active to passive trading styles, which generally includes more algorithmic and program trading that is many multiples cheaper than the active investment styles.

In light of this declining environment, many institutional investors see the current models offered by some brokers as unsustainable and in need of a refocus.

The crisis isn’t the only reason to revisit broker lists and concentrate flows with fewer brokers. Last week’s trading glitch at US-based Knight Capital, which caused a US$440 million loss and has required the broker to look for refinancing, has only exacerbated fears. Moreover, recent scandals at J.P. Morgan, MF Global and Peregrine Financial Group – the latter two of which included improper segregation of client funds – mean now more than ever, buy-side is keeping close tabs on its sell-side counterparts.

But surely some brokers must have changed business models following the fallout from the financial crisis? 

There are some brokers which have scaled back their equity businesses following the crisis, with ICAP opting to focus on execution rather than a full-service offering, and RBS exiting cash equities altogether earlier this year.

A more recent trend has been for brokers to combine high- and low-touch service offerings. Citi and Credit Suisse have been among the brokers undergoing an integration of sales trading and electronic trading capabilities.

In the agency brokerage world, low volumes have meant there is simply not enough flow to maintain an execution-only business. This is evidenced by the recent disposals of CA Cheuvreux and CLSA, the respective European and Asian agency brokerage subsidiaries of Credit Agricole.

What are the practical challenges of consolidating broker lists? 

The lack of meaningful unbundling in Europe – the practice of splitting up commissions paid for research and execution – means it is difficult for the buy-side to figure out which brokers offer the best results for specific types of trades.

This makes determining which brokers to concentrate flow with a challenging task. Brokers are likely to try and offer bundled services for as long as possible, thereby forcing buy-side clients to purchase more services than they require.

Buy-side firms also have to consider whether they have a penchant for agency brokers or full-service houses. The former do not offer risk or facilitation services, valuable for firms that want to trade blocks of stock, while the latter are finding themselves under increasing pressure to reduce budgets and headcount.

The best bet for buy-side firms may be to keep a core list of fewer counterparts, with a longer ‘tail’ of smaller or specialist brokers that they can use infrequently for trickier, more challenging trades.

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