Brokers are outsourcing their dealing desks to other sell-side firms. Dan Barnes investigates what is left of a broker that does not trade.

Commissions paid to brokers are falling. Partly, this is a result of falling trading volumes. Partly it is a consequence of the separation between payment for research and for trade execution, which historically have been bundled together. The upshot is that trading no longer pays the bills and some brokers are reviewing its status as a core function of their business.

"Over the years, the average commission rate has gone down from 25 basis points (bps) to between 8bps and 12bps,” says Adrian Fitzpatrick, head of Investment Dealing at Kames Capital, a buy-side firm with £53bn ($88.05bn) in assets under management. “Brokers can't make money in equities because it is so transparent. There are huge regulatory and compliance obligations that they have got. Maybe the only way forward is to take the equity market to net commission [as used for fixed-income and foreign exchange where asset prices include commission].”

Commissions fall

Greenwich Associates, a capital markets research house, estimates that the annual commission payments to US brokers in the 12 months to the end of March 2013 had fallen by 33.6% since the equivalent period in 2009, from $14bn to $9.3bn. Over the 12 months to the end of the second quarter in 2013, Greenwich Associates saw the US commission pool contract by 15%.

Analyst firm Tabb Group saw commission in Europe drop 27% in 2012, rising 9% again last year, but predicts a fall of 7% in 2014 in its report ‘European Equity Trading 2014: Part 1’. Its author, analyst Rebecca Healey, writes: “Several participants spoke of the increase in [2013] activity being due to fund rationalisation on the back of poor activity in 2012 requiring one-off portfolio adjustments rather than any sustainable rise in trading. Even for those whose activity is increasing and execution spend is higher, total commissions paid are likely to lower unless there is a significant increase in emerging market activity, which typically charges higher commission fees.”

Thomson Reuters’ data shows there is no such corresponding decline in equity market turnover, a margin of which would typically reflect the value of commission paid to brokers. That dislocation implies the decline in commissions is not due to a reduction in trading activity over that period. Instead it reflects a reduction in the margin taken on that trading activity.

“Following fierce competition, the price of execution is falling, while at the same time there is a greater obligation to provide quality execution services at an agreed level," says Julien Kasparian, head of UK sales and relationship management for banks and broker-dealers at BNP Paribas Securities Services, which has taken on the trading operations for several brokers. “Not all of the players can make money out of execution. Rather than stop offering execution, brokers are instead choosing to outsource their trading to a firm that can make the economies of scale work.”

Exposing execution

There are several factors that are lowering returns for sell-side firms. The first is the unbundling of research and execution. Research payments to brokers are no longer hidden away alongside execution costs but often split out within commission payments.

Peter Tarrant, head of business development and capital introduction at US broker BTIG, which offers outsourced trading to buy-side firms, says that although he has not seen brokers outsource trading, historically there has been interest from brokers in BTIG's outsourcing services, which has fallen down over cost. Nevertheless, he says that those discussions have made the motivation to attempt to outsource clear.

"As commission rates have been unbundled, the charges for execution have fallen, and automated trading is also conducted at a lower rate; that changes everyone's mind-sets. It’s a difficult environment to say the least; the regulatory environment is tougher and it is harder to operate as a small broker. They have to constantly reinvest in technology and there has been a decline in average commission tickets. These businesses will be more profitable if they can isolate their high-margin activities from high overheads,” says Mr Tarrant.

Commission sharing agreements (CSAs) in Europe and client commission arrangement (CCAs) in the US are agreements that an investment manager and a broker set up to split commission payments into separate buckets to pay for execution and research. By charging this through commission, the investment manager is able to pass the costs directly on to the investor, as broker fees are charged direct, rather than billed as part of their own services.

When commission is ‘unbundled’ in this way, the broker is required to take a proportion of the commission paid on each trade and hold it aside to be used to pay for research. The investment manager must then pass on instructions as to whom should be paid from the research bucket and when.

"The buy-side will eventually force the sell-side to unbundle due to regulatory pressure,” says Mr Fitzpatrick. “We have research budgets this year, not targets, and as soon as we reach that budget with a broker we will go execution-only. The better execution houses will survive but many will find that they can’t run research across all sectors. The issue is that mid- and small-cap research may get missed off completely."

Unbundling, unraveling

Without CSAs/CCAs, buy-side firms are obliged to use research providers that also provide execution services in order to pay them directly through a commission payment, with an inevitable compromise between execution quality and research.

In 2012, the last full year for which analysis was conducted, Greenwich Associates data shows that commission agreements were used for about 34% of US commissions and for 41% in Europe.

In the UK, market regulator the Financial Conduct Authority (FCA) stated in December 2013 that it planned to include rules on unbundling in the review of Markets in Financial Instruments Directive II (MiFID II), which is expected to go live across Europe in 2016.

Mr Fitzpatrick says that as a result of this pressure, brokers have begun to offer alternative pricing models but these still do not include menu pricing.

“Why should I be taking oil research from a broker whose oil research I don’t rate?” he asks. “I think that, post-FCA review, they are going to have to look at what their models are, and for the most part it is an old model that doesn't work. Regulators have put pressure at the level of chief investment officer and chief executive to justify what the commission spend is and what they are doing with their clients. I believe that research and sales operations over the next 18 months will be cut by between one-quarter to one-third.”

Race to the bottom

Another pressure on trading operations is increased competition and a need for co-operation. Regulators brought in best execution obligations in the US (Regulation National Market System) in 2006, and Europe (MiFID) in 2007, which have facilitated price transparency in the equity markets. With competition based on pricing, a race to the bottom has ensued.

"Although trading is core [to a broker’s business], after MiFID the market was hit by the financial crisis and I don’t think anyone anticipated how the two would combine,” says Mr Kasparian. “MiFID was meant to introduce competition in the market and ultimately price reduction for trading in Europe. What it did was increase fragmentation, driving prices very low – even too low. At the same time trading volumes began to fall."

Many brokers chose to match client orders with other client orders internally, rather than struggling to find liquidity in the fragmented market, by using their own crossing networks, or dark pools. This further increased fragmentation for other firms and necessitated brokers to begin using one another’s pools in order to have the widest access to liquidity.

“The concept of outsourcing is already well entrenched in broking, albeit often not formally announced,” says Tony Nash, head of execution services at Espirito Santo Investment Bank. “We are semi-outsourced in that we have exchange memberships in most markets, but run the vast majority of our business via third-party brokers. We manage that using algorithms and direct market access to get access to 16-plus broker dark pools and that works incredibly well.”

What has been changing, according to Adam Toms, chief executive for the Europe, the Middle East and Africa region at agency broker Instinet, is the extent of outsourcing.

“The point of outsourcing has gradually been moving up the order flow chain,” he says. “The simplest piece of outsourcing in equities is execution; if you are not a member of an exchange you get another broker to execute and that has been around for many years. Moving up the chain, if a firm doesn't want to invest or continue to support its own algorithms, it can use another broker's algorithms and smart order routing to execute. The step up from there is managing and routing orders, using the execution management system of another broker or vendor to enter orders down through the chain.”

Evolution in motion

Banks are fielding enquiries about trading desk outsourcing through a variety of routes. Japanese investment bank Nomura began to move its non-Japanese equity trading to subsidiary Instinet in late 2012. The move got rid of a duplication that had existed between Instinet’s equity business and that of Nomura’s equity trading operations, which it had largely acquired from defunct broker Lehman Brothers in 2008.

Mr Toms says while the project did not provide an exact match for third-party outsourcing, as duplication reduction was a large driver, nevertheless it led to interest – and business – from other banks. “The move we made on behalf of Nomura led to us receiving several incoming calls, asking if that was something we could do outside of the group,” he says. “We have spent quite a bit of time securing a variety of outsourcing mandates as a result.”

Some European custody banks have been approached to outsource the front office as an extension of discussions about outsourcing middle- and back-office functions, say market sources. "Not all of the players can make money out of execution,” says Mr Kasparian. “Rather than not offer execution, brokers are instead choosing to outsource their trading in exchange for scalable volume and flow.”

He notes that where firms have commoditised operations, including market-making and corporate brokerage, many see the execution part of the business as a cost that can be managed by a firm with scale.

“For research driven firms execution is not core but it still offers them the position of being a full-service broker so rather than become a research house they outsource trading to a firm that is good at it,” says Mr Kasparian. “We see firms becoming sales fronts for primarily outsourced operations.”

No limit

As long as a firm’s model was correctly represented to clients and potential clients, there is no reason to limit the extent to which a firm can outsource its business, says Mr Nash, as this could potentially allow it to offer a truly best of breed service.

“A firm could outsource its front, middle and back office – depending on how it was marketed to the client base,” he says. “The market is moving towards an optimised model, where there are pockets of people who are extremely good at skills, such as market making, dark pool access or getting access to the emerging markets. People are optimising the outsourced model and are cherry-picking the products they want access to. They are taking their execution process and outsourcing them partially or entirely; if execution outsourcing were to happen in its entirety it wouldn't necessarily be a bad thing.”

Mr Fitzpatrick says that existing technology-based outsourcing arrangements have been accepted without issue, but that from a client’s perspective the effect and acceptability of outsourced trading would depend upon who the broker is and whether it offers a full-service broker operation.

“You wouldn’t want a full-service broker to outsource their trading operations, but in the algorithm space there has been white-labelling of technology to a certain degree," he says.


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter