Despite the ups and downs the equity markets have faced in recent years, commission costs for buy-side firms have trended down overall in most markets, but could the current reduction in trading volumes spark a reverse?
Portfolio managers typically have a greater need for high-quality research and other sell-side services such as corporate access when economic uncertainty threatens investment returns. For those asset managers that are not fully unbundled, it may be necessary to increase commission rates to ensure PMs still get good exposure to trade ideas.
Commission in Europe and many other markets is usually paid to a broker as a percentage of the value traded, while in the US it is paid in terms of cents per share. The US has seen a fall in average commission rates from 2.53 cents per share in 2006 to 1.74 cents per share in 2009, according to research firm TABB Group, with nearly half of buy-side firms claiming their net payout for 2009 was between 20-30% down on 2008. In Europe from Q2 2009 to Q1 2010, average commission levels moved in line with the volume of pan-European equity trading volume, mirroring the spike and dip in activity in Q4 2009 and the recovery in Q1 2010, figures from agency broker ITG indicate. Anecdotally, the last few years have seen commission rates fall all over.
A big contributory factor to this drop has been the increased use of algorithmic trading and direct market access. Market fragmentation and the growth of non-displayed trading venues in the US and Europe have made the task of finding liquidity more difficult and algorithmic trading strategies and smart order routers are increasingly being deployed to seek it out.
But while such low-touch approaches generate lower levels of commission than high-touch execution via sales trading desks, the latter are still in demand, particularly in times of greater market volatility, as experienced in both Europe and the US in May. Overall, excellence in execution is required across the board to keep trading costs consistently low, while high-quality research is also valued at a premium to help generate alpha. Only the very largest firms have the resources to deliver top-ranked execution and research on an ongoing basis, but the evolution of a research- and execution-only tier is still slower than might have been expected.
Part of the reason is the uneven progress toward unbundling of payments for execution and other broker services, and the adoption of suitable mechanisms to provide greater transparency.
The unbundling of payments to brokers for execution and research using commission sharing agreements (CSAs) has provided many firms with a greater ability to analyse their costs, thus rewarding quality of service appropriately and enabling brokers to realise their strengths. By specifying that a certain proportion of the commission paid by a fund manager for dealing will be kept aside to pay for research, CSAs ensure the flow of trade ideas while helping the broker by identifying whether its traders or its sales team are driving client relationships and revenue stream.
But the practice of implementing CSAs is far from consistently implemented across global institutional investors and many of the barriers to putting a price on research remain. This means many fund managers, particularly in the mid-tier bracket, may be tempted to increase their commission rates in the months ahead to demonstrate to brokers that their relationship is worth maintaining.
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