Following up on my last blog about commission sharing arrangements and client commission agreements (CSA credits), I wanted to talk about some of the unexpected consequences (or requirements) that fall out of offering these arrangements. Nothing here is bad or problematic, unless you don’t understand it or are ill-prepared to address some additional client needs.
Based on recent news in the trade press and feedback from recent meetings, it appears that commission dollars and volumes for some agency broker dealers are starting to grow again. That’s good news. We think it’s driven in part by the use of Commission Sharing, CSA agreements and the access to new research.
However, this also has another consequence. Clients want to view their unbundled execution costs, seeing how much they are paying for this research as well as having greater transparency into their execution costs. In fact, it’s clear that clients are asking for cost-plus arrangements.
What does this mean? Well, in order to maintain that client, you’ll need to systematically calculate the specific costs of each trade, including maker/taker fees, complex exchange fees, SEC fees and other charges. Clients now expect you to charge them these explicit fees with an agreed upon mark-up. No longer can you charge the typical $0.04-$0.05 all-in commission fee.
The moment you fail to show these explicit costs and verify the mark-up, you’ll lose those clients and commission dollars to the next broker-dealer who can. You’ll have lost a client and wasted the resources that acquired in the first place. Even as commission dollars begin to rise, no one wants to take for granted a client relationship and lose it simply due to their inability to provide transparency and cost-plus billing.
Are you prepared?
Over the past several years, with the market meltdown and the ‘flash crash” last May, overall commission dollars have continued to fall in capital markets. In 2010, commission dollars were down over 20%. There are projections of another ~20% drop in commissions for 2011 as well.
In the years leading up to the meltdown, brokerages had been reducing their execution costs to retain and/or grow revenues. A large shift to electronic trading, algos, and improved smart order routing shaved points off commissions rates and lowered the costs of execution.
However, in the past two years, execution isn’t the only issue. The buy-side is actively looking for “alpha-generating” ideas through better research. It’s been reported that more than 75% of buy-side firms use some form of commission sharing arrangement (CSA) to gain access to the research they need to lure retail customers back and improve the overall picture in capital markets. The other 25% is increasingly moving toward the use of CSAs as well.
Bulge bracket firms continue to invest in research and technology as full-service brokers, because they can afford to do so. The rest of the execution-only brokers will find it increasingly difficult to compete for commission dollars without research and CSAs to entice the “alpha seeking” crowd.
In the past two years, Firm58 has helped some of the leading brokerages create and manage CSA programs through our hosted technology solution. Our Software as a Service (SaaS) subscription model lends itself to institutional brokerages of all sizes because infrastructure and hardware costs are eliminated.
Firm58 is committed to continuing our focus on CSA program management. Recently, we added Mike Plunkett to our Board of Directors. Mike was President of Instinet, a company that had one of the most successful and longest-running CSA programs, ever. Mike’s insight into the market is already translating into actionable solutions for our clients and our company.
How well prepared are you to handle this need for more and better research? Learn more about our CSA/soft dollar offering.
It surprises me that many broker-dealers we talk to still consider the act of “billing” or “invoicing” their clients for monthly trade activity an operational task, rather than a strategic leverage point. In an era of decreasing commission dollars and greater competition for order flow, shouldn’t everyone be looking to gain every advantage to maintain existing customer business, if not increase business?
At Firm58, we see two main reasons why broker-dealers are stuck in this operational mindset. First, some BDs simply state that “we’re charging ‘X’ mils and making a profit, why do I need to change?” The truth is, each customer has a unique set of demands, and receives differentiated levels of service.
Two retail customers don’t walk into a grocery store, fill up a shopping cart each and get charged the same amount of money for a shopping cart full of groceries. It all depends on what was purchased. Might the store make a profit with this strategy? Sure. In the short run, the average price might compensate but, over time, those that require less (or fill up the cart with less expensive goods) will shop down the street where they’re charged only for the goods they purchased.
On the other hand, those that fill up the cart with expensive items (are provided more than what they are paid for) will continue to fill up the cart with expensive goods and become smarter about asking for more, at the same price. Soon you’ll be left with customers that are eating away at profits, and your business will suffer.
Differentiated pricing that represents the costs of the services provided isn’t new in capital markets; it’s just sometimes ignored in favor of an “overall profitable trading business.” Shortsighted decisions like this come back to haunt firms.
Second, many firms don’t have the systems to properly charge for the services provided with a mark up for their costs, thus have to rely on a flat rate. Why is this so hard? Well, measuring the daily costs of trades made across many exchanges with complex fee structures, maker/taker fees, etc., is difficult. It takes investments in infrastructure and resources to manage this properly. These investments are typically viewed as “operational” and do not get the same level of commitment as those viewed as strategic (i.e., revenue generating).
But imagine being able to use this execution cost data to support smart order routing, or simply provide greater transparency to customers for compliance. If you consider all of the possibilities for tracking costs at this detailed level you’ll see it’s not a tactical cost, but in fact a strategic investment in your business and your customers.
For those that get it, pricing and billing both present a unique opportunity to differentiate services, maximize revenues of existing business, and generate new business (e.g., by offering competitive cost-plus billing). Those businesses that address these functions strategically will thrive in all economic cycles, not just the upswings.
Today, Traders Magazine Online posted a story by John D’Antona Jr, entitled “Buyside Wants More Transparency of its Orders.” According to the article, “traders expressed these views on order routing disclosure on a panel at last week’s Investment Company Institute’s conference on equity trading in New York.” They go on to say that “daily disclosure of trading and routing data is fair and reasonable.”
So why hasn’t the sellside provided this information to their trading clients? The sellside firms generically referred to in the article claim that “[t]racking orders can be an arduous and time-consuming task…getting data from all the trading venues can increase the likelihood of information leakage, which compromises brokers’ desire to maintain customers’ privacy.” I think that argument has little merit. I believe the reason why sellside firms cannot provide, and do not provide this information is because they don’t have the middle office in place to capture, normalize and provide secure access to their buyside clients.
Brokerages need to provide this access and flexibility in order to keep its client base and protect revenue. The buyside wants to use this information, in part for compliance to see “where brokers receive rebates…[to] determine if the brokers are meeting their best execution obligations.” Those brokerages who do not provide daily access to this information risk losing their trade flow. As important, transparency and compliance obligations are growing and I can foresee a world very soon where in near-real-time, brokerages will have to make available this information to it’s customers.
It’s time for brokerages to quit limping along with outdated and ineffective spreadsheets and invest in technologies that have been around for the better part of the last decade. Falling behind isn’t an option.
The SEC announced yesterday its ban on broker-dealers providing “naked access” to traders, most notably referring to some of the smaller High Frequency Trading operations that do not have their own direct access. According to published reports, more than 30% of the trading in U.S. markets is conducted through naked access.
It’s hard to argue with the SEC’s decision. While I am not personally one who likes too many controls and oversights into business, this decision seems to be consistent with public sentiment — both business and investor — to add more transparency, accountability and proper risk controls into the market. After the dramatic events of the Flash Crash in May 2010, the SEC is addressing market participant concerns that unmanaged market access can cause unforeseen events, and helps investors gain confidence to re-enter the U.S. equity markets.
Firm58 is a proponent of sponsored market access. These services offer great benefits to the U.S. markets by way of greater deal flow and liquidity, but with the proper safeguards around risk and accountability for the individuals using such access. Recently, we announced a relationship with LightSpeed Financial who, among many other things, provides sponsored access to its clients. Firm58 will be providing core middle- and back-office solutions to help LightSpeed Financial manage this activity and provide greater transparency in the process.
It’s great to see the SEC realize the benefits of proper sponsored access and continue to support that business model, while addressing the greater market and investor concerns of naked access. Firm58 is well-positioned to help capital markets firms reap the benefits, transparency, and accountability of such controls while improving operational efficiencies and protecting revenue.
Over 5 years ago when our founders created Firm58, one of the core principles was that changing market structure (i.e., more trading venues, digitization, etc…) was making post trade financial analysis & reporting exponentially more complex. They were clearly right. Everyone knows how hard it is to, daily, look at your OMS records, your clearing files and try to reconcile what happened across which “markets” and at what fee/rebate. Customers demand more transparency into their trade activity. Companies are scrambling at best to keep up. The largest brokerages are scrambling to make sense of all this post trade data in order to reduce their Brokerage, Clearing and Execution costs, which typically represent the 2nd or 3rd largest spend in their organizations.
While I was at the Rosenblatt Financial Technology Summit in New York two weeks ago, Joe Gawronski (President) and Justin Schack (Director of Market Structure Analysis) led off the conference with a talk on regulatory reform and the impact on competition in the industry. In that talk they reviewed some of the historical facts that have lead to today’s market structure. In particular, two slides (shown here) detail the changes in market structure from 1997 to now, and put some hard facts around this problem of market fragmentation and complexity. The duopoly in US Equity Markets we knew 13 years ago has been replaced with at least nine market places or venues making up almost 98% of the volume.
What does that mean for you? As we’ve been saying for years, if you’re a brokerage of any size, and you’re trying reconcile monthly exchange invoices and fees against your daily trading activity, good luck. Spreadsheets and MBA’s are working overtime to give you (at best) averages and a high level view of the business. Granular trade by trade analysis, and detailed views of clients is impossible without a system to help you. With the pending changes in regulations and compliance around trade detail and transparency you will clearly be at risk.
Next week I’ve been asked to attend the 2nd Annual Financial Technology Summit in New York put on by Rosenblatt Securities. Thanks to Vikas Shah and the team at Rosenblatt Securities for inviting me to the event. I’m really looking forward to it.
I will be part of a panel discussion that day entitled: Demystifying Post-Trade: Understanding back office innovations can pay dividends. We’ll be discussing the shifts in regulations and compliance, along with the ever changing demands of customers for greater transparency into their trading fees. With transaction volume and commission dollars shrinking, and with regulations and compliance increasing the demands on trade by trade transparency, there’s a bigger requirement on the sell-side to more accurately and more timely process, account for and report on daily trading activity, including the measurement of client profitability.
The panel is going to dive into the post-trade problems and discuss potential solutions. It’s next Thursday, September 30th in New York and I’m sure I’ll post some comments here after the event.