U.S. equity brokers say the pool of equity commission dollars they earn on institutional trades of domestic equities could contract by nearly 25% in 2009—a reduction that could prove problematic for sell-side firms and institutional investors alike.
According to a new Greenwich Associates study, from 2008 to 2009, the amount of commissions paid by U.S. institutions to equity brokers on trades of domestic stocks grew 12% to $13.7 billion. However, earlier this year, sell-side firms projected a decline of 23% in overall equity commission revenues for this year, with an even more severe 32% contraction expected in hedge fund commission payments. The end result: a likely drop in total domestic equity commissions to 2007 levels.
Last year's surge in equity brokerage commissions was driven in part by the forced sell-off of U.S. stocks, which represented one of the few sources of liquidity for institutions in need of funds to cover deteriorating positions in fixed income and other areas of their portfolios. Also contributing to the historic trading volumes was hedge fund deleveraging — a process that appears to have largely run its course.
“While the rebound in U.S. stock prices in the second quarter is likely to mitigate the resulting decline in commission payments, any significant reduction will be a challenge for brokers that are counting on client-driven capital markets businesses for revenues following the collapse of mortgage and sub-prime businesses,” notes Greenwich Associates consultant Jay Bennett.
By increasing the pressure on broker-dealers, the decline in commission revenues could result in cutbacks on sell-side equity sales coverage and research/advisory services. These reductions would come at a difficult time for U.S. institutions, which are still coming to terms with huge declines in portfolio asset values and in many cases are looking to outsource aspects of their investment and trading functions to the sell-side as part of their own ongoing cost-cutting efforts.
Institutions Look to Trim Trading Costs
Several of the major trends uncovered in this year's research reflect a concerted effort on the part of hard-pressed institutions to reduce costs and maximize the value they get from the commission dollars they do spend.
The primary strategy used by institutions to reduce U.S. equity trading costs is to shift trading volumes from traditional “high-touch” trades facilitated by broker sales traders to relatively low-cost electronic execution. The proportion of overall U.S. institutional equity trading volume executed through high-touch trades slipped to 56% in 2008-2009 from 60% in 2007-2008, while the share of volume directed to electronic platforms increased to 36% from 32%.
The switch to electronic trading generates significant cost savings: the average commission rate on a “high touch” trade has been unchanged at about four cents per share since 2008; the average rate on “execution only” electronic trades declined to 1.6 cents per share in 2009 from 1.7 cents in 2008. The movement of trading volume from high-touch trades to electronic platforms has driven down institutions' “all-in” blended commission rate to an average 2.9 cents per share in 2009 from 3.2 cents in 2008.
When they do use high-touch trades facilitated by sell-side sales traders, institutions are increasing the amount of associated commissions used to compensate brokers for research and advisory services, while directing fewer commission dollars to pay for sales and trade execution. In fact, the mix of research/advisory vs. execution spend has shifted from approximately 50:50 to 55:45 and the commissions used to compensate brokers for research, institutions are allocating a growing share to reward brokers for analyst service — a sign that some institutions are relying more heavily on the sell-side for day-to-day research support.
Capacity Constraints: A Growing Buy-Side Concern
As institutions shift trading volumes to electronic platforms, some of the functions and responsibilities formerly provided by sell-side sales-traders must be taken on by the internal trading desk. As such, increases in electronic trading volumes increase the workload for buy-side traders and should raise concerns about possible capacity constraints.
Institutions expect to increase the share of their total trading volume executed electronically from the current 36% to 41% by 2012. Rather than gearing up for these increases by hiring more traders, U.S. institutions actually cut back on the number of traders they employed last year, with the overall industry average falling from 3.9 traders in 2008 to 3.6 in 2009.
“Institutions are being quite aggressive in their cost-cutting efforts, but they must be careful that they do not go too far,” says Greenwich Associates consultant John Colon. “Shifting trading volumes to electronic platforms can reduce trading costs, but it also increases the work-flow pressure on the institution's trading desk.”
“The shift also reduces the amount of commissions that the institution has available to obtain support from the sell-side in the form of sales coverage and research/advisory services. Taking this step while also reducing headcount on buy-side trading desks could prove problematic.”