I was at a buy-side head traders conference recently when the host broker's head trader commented that his firm wanted 35 percent of its clients' equity flow. After the buy-side traders and I got off the floor from laughing so hard, the trader proceeded to add that the broker was cutting its named-account list by half and if buy-siders wanted top-tier support, they would need to increase their flow (aka commissions) through the firm or they wouldn't make the cut.
I'm sure the broker's head trader was not drawing a line in the sand. But if this was not just hyperbole and it truly represented the firm's direction, these statements have huge ramifications.
Currently, large firms (with more than $150 billion in assets under management) split approximately 75 percent of their order flow among, on average, about 14 core brokers. If the flow is parceled out evenly, it averages 5.25 percent of flow for each of the 14 core players. While brokers at the top of the list certainly receive more than 5 percent, I doubt few, if any, major buy-side players concentrate 35 percent of their flow with any single broker.
However, as Bob Dylan once said, "The Times They Are a-Changin'." With the migration of order flow from high-touch to low-touch channels, and a 22-percent decline in the buy side's blended commission rates and a 26-percent decline in algorithmic commissions from last year alone, brokers increasingly are under pressure to increase efficiency, reduce costs and gather flow. This is especially true if commissions continue to decrease at the current pace and brokers need to increase their capital provision and profitability from order-flow interaction (read: prop trading).
Juxtaposed with this is the fact that buy-side firms are under increasing pressure to generate alpha, requiring increasing access to ideas, data and liquidity from global markets, derivatives and structured products.
Are these two trends in parallel or in conflict? Will buy-side firms' need for alpha force them to consolidate their flow with two or three brokers? Or will the brokers' call for greater order flow concentration and less support actually work against them by providing opportunities for smaller-tier brokers?
Both are accurate. While it is highly unlikely that a large manager will ever concentrate 35 percent of its flow with any single broker, the trend is unmistakable: Buy-side firms are concentrating their flow. They are using commission-sharing agreements to reduce their trading relationships and concentrate their flow with brokers they believe will provide them with best-of-breed trading tools and algorithms and facilitate best execution. However, if larger players' requirements become too onerous, concentration levels too high and service levels too low, we will see opportunities for smaller-tier brokers to develop niches or even segments in which they can provide best-in-class service with much less stringent order-flow demands than top-tier firms.
So will we see consolidation? Yes. Will we see opportunity for the smaller tier? Yes. Is the agency model dead? I doubt it. As we move into 2008, there will be increasing opportunity for all; however, participation will increasingly require firms to operate at significantly higher sophistication levels.
The drive for alpha will require significant support. But it will be increasingly important for firms (especially small and midtier firms) to focus. Brokers will need to lead. They will need to demonstrate mastery in at least one value segment, be it research, analytics, trading, technology, securities finance, derivatives, capital, geographic dominance or cross-asset support. Just being average will not cut it. Firms will need to be superior to not only gain mindshare but market share.
So the key word for 2008 is focus. Focus on differentiation, focus on generating alpha, focus on providing value and focus on being the axe. The broker axe needs to be sharp, it needs to be cutting-edge and its strikes need to be well placed; otherwise, the glancing blow from a dull axe may cut off the wrong limb ... namely your own.Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio