FEELING THE SQUEEZE.

Asif Abdullah* explains why managing down the cost-per-trade is key to survival for mid-sized players. 

Although global equity market indices, including the S&P500 and the FTSE100 have recovered to pre-crisis levels, this has not resulted in an increase in equity brokerage fees. Client trading volumes which drive brokerage commissions continue to remain depressed. Industry research shows that the global equity revenue pool in 2012 was 55% of pre-crisis 2007 levels (see Fig. 1) while reduced primary activity, such as IPOs, has curtailed secondary market activity.

As a result many firms have been forced to strategically review their equities franchises, which has resulted in downsized or shutdown business lines.

The reduced revenue pool has increased competition amongst brokerage firms. Market-leading equities houses, which have maintained a full service offering, have successfully increased market share at the expense of mid-tier and regional firms.  These global firms have maintained profitable business lines by continuing to exploit volume-driven economies of scale and, increasingly, they have benefited from cross-asset flow by implementing multi-asset platforms.

Mid-tier or regional firms, on the other hand, are encumbered by expensive technology and operational platforms designed to manage pre-crisis volumes. What this means is the fully loaded cost per trade for a market leading-firm is significantly less than for a mid-tier firm. This is illustrated by Fig. 2. The ‘Squeeze zone’ is where firms have high cost bases and cannot benefit from economies of scale.

For many equities businesses, reduced brokerage revenue coupled with a high cost base has resulted in negative or near negative return on equity, forcing banks to make difficult strategic restructuring decisions.

In the context of reduced profitability, technology platforms need to align to the new business reality. Three key trends in the market are emerging as a response to this: the merging of high-touch and low-touch flows, the commoditisation of trade management functionality, and the deepening of vendor relationships.

Merging of high touch and low touch

When full STP and electronic trading truly became possible in the late 1990s, brokers found their traditional high touch platforms could not service the demands of clients who wanted fast, reliable and scalable execution capabilities. Early market entrants developed in-house low-touch platforms to sit alongside existing high-touch platforms. Later market entrants have since taken advantage of the lessons learnt from the earlier entrants with many using vendor solutions rather than building in-house platforms.

Over time, high- and low-touch platform functionality has converged with high-touch platforms now incorporating many of the performance enhancements typically offered by their low-touch counterparts. Low-touch platforms offer functions over and above a simple DMA offering, for example enabling brokers to intervene during execution, providing FIX access to broker algorithms, and more.

This convergence of functionality is expected to continue, eventually eliminating the need to maintain two distinct platforms. Low-touch platform vendors have been continuously enriching functionality to meet high-touch requirements and are well positioned to dominate the converged market.

Commoditisation of key functions

As electronic trading in equities has matured, much of the trade management functionality has become commoditised as presented in Fig. 3, but many of these functional components offer very little in the way of competitive advantage to the bank.

Many software vendors now provide off-the-shelf solutions which are integrated with the broker’s own systems. In particular client connectivity, order management, execution management and the provision of market data have been fully commoditised. Brokers can continue to secure competitive advantage from functions such as programme and algorithmic trading.

In the context of reducing investment budgets and increasing cost pressures, many firms are migrating these commoditised components from in-house to vendor solutions and as a result, firms are able to direct valuable internal resources to areas that still provide competitive advantage.

Deepening of vendor relationships

In addition to increasing the use of vendor technology within the trade management service stack, brokers are looking to vendors to provide increased levels of service – from the provision of enterprise software licencing, integration resourcing, on-going maintenance of software, hosting of hardware and the running of vendor software to a fully outsourced model where the vendor is responsible for complete operation of the software and supporting infrastructure. Fig. 4, summarises five main types of vendor engagement relations.

Fig. 4 – The deepening vendor relationships

The deepening of vendor services presents challenges and opportunities for the broker as summarised by Fig. 5:

• The broker may feel a loss of control as the vendor takes on more responsibility. As a consequence operational risk may increase.
• An increase use of vendor services places greater emphasis on relationship management skills. Effective relationship management is critical in an outsourced environment. The broker may have to review the skill profile of their internal team. The vendor and broker internal teams should have common objectives and incentives should be aligned. A partnership type relationship should be nurtured.
• Using an outsourced service model provides the broker with scalability. The broker has the opportunity to flex resourcing or systems capacity in line with requirements. Vendors with several clients can smooth out the peaks and troughs of demand.
• The broker also has the opportunity to move from a fixed cost model to one with a larger element of variable costs and thereby manage down the cost per trade as volumes fluctuate.

We’ve seen the closure of many equities brokerage businesses in the last few years, most notably RBS’s. This too, will be the fate of brokers who fail to manage down their cost-per-trade in an environment where regulatory pressures are increasing and where clients are becoming a lot more circumspect about where they transact their business, brokers who fail to manage down their cost-per-trade will continue to suffer.

Dismantling large, monolithic software architectures is necessary for mid-tier houses who are fighting to survive and those who can do this, and recalibrate their focus towards the areas that truly provide a competitive advantage, will succeed.