Brokers face grim prospects for 2013
Brokers are being forced to consider novel approaches to doing business – including outsourcing of areas that have been previously seen as core – as they struggle to work out viable economic models for their products and services.
“The traditional brokerage model can’t continue,” said Rebecca Healey, senior analyst at Tabb Group. “There isn’t the flow in Europe to pay for broker services. Firms are being forced to rip up the rule book, as austerity deepens.”
A novel deal between Norwegian broker Christiania and execution specialist Neonet, in which the broker outsourced its execution, may point the way to the future.
Christiania Securities focuses on technical stock analysis in Nordic markets, including the Oslo Stock Exchange. According to Oddbjørn Hollen, chief executive, the firm made a strategic decision to outsource its execution so that it could focus on its core business – providing advisory services and research.
Under the deal, Christiania will use Neonet’s execution services on a pay-as-you-go model. The idea is that the broker will save money by ridding itself of the need to form and maintain expensive exchange memberships, and costly in-house resources such as IT and R&D staff dedicated to execution technology.
“Neonet is connected to many markets,” he said. “It is better for us to tap that network rather than attempt to pay for it ourselves. They also have many algorithms, which we would have to buy or develop separately if we were providing execution ourselves. The cost savings are significant.”
A long cold lonely winter
The dilemma faced by Christiania is representative of the pressures on sell-side business in general. Commission revenues have fallen significantly since the financial crisis, with a 29% fall this year alone, according to TABB Group. At the same time, equity trading volumes have collapsed and show little sign of emerging from a prolonged slump. European equity trading volumes have fallen from €1.253 trillion in October 2008 to €651.636 billion four years later and just €603.699 billion by November 2012, according to figures provided by Thomson Reuters.
To make matters worse, an oncoming tide of tough financial regulation has brought the need to invest in new technology for compliance and reporting. Legislation such as Basel III imposes higher capital requirements on banks, while Dodd-Frank in the US and EMIR in Europe introduce additional costs by mandating the centralised clearing and reporting of OTC derivatives. Other rules included in Dodd-Frank and MiFID II in Europe impose tighter regulatory scrutiny and tougher sanctions for firms that break the rules.
In a recent whitepaper, Survival of the fittest part II – Walk the line, Steve Grob, director of market strategy at technology provider Fidessa, argued that drawing a distinction between business areas that add value, and sources of cost that do not, could make the difference between success and failure. “Firms must challenge the traditional idea that all technology investment is a source of value,” he said. “A more radical approach is required.”
The immediate financial advantage of outsourcing is the replacement of fixed costs with variable costs, which then enables the firm doing the outsourcing to adjust more flexibly to changing market conditions. Solutions such as cloud technology, in which companies effectively outsource much of their IT hardware, software and support infrastructure, have become hugely popular among many businesses for their cost saving potential. However, large financial institutions have traditionally been reluctant to accept the cloud, partly due to concerns over the security of information held on a cloud server.
Recent months have seen that position substantially erode. In September, exchange group Nasdaq OMX launched a financial cloud service with help from Amazon Web Services. Others are still considering their next move; France’s Société Générale is reported to be considering outsourcing 400 jobs in its back office to consulting company Accenture. But there seems little doubt that cloud technology and the associated outsourcing of non-core business will continue to grow in popularity.
“Customers want value-added services,” said Tabb Group’s Healey. “Today, there is still a lot of unnecessary duplication. Outsourcing agreements that enable firms to play to their greatest strengths are likely to become increasingly common.”
Christiania outsourced its execution business because it saw research and advisory services as more core to its value proposition as a company. That decision reflects the fact that execution has itself become increasingly commoditised in recent years. On the sell-side, brokers increasingly field essentially the same sets of algorithms, while on the buy-side, investors are increasingly switching from stock-picking, which has produced poor returns since the financial crisis, towards the use of electronic trading, including algorithms. According to recent Tabb Group research, 66% of buy-side traders surveyed are switching away from sales traders in favour of algorithms.
Treading on ice
Despite increasing levels of commoditisation, opinions among the buy-side remain divided over whether outsourcing execution is the best solution. Some 62% of respondents to the Tabb Group survey saw electronic execution as the most important service provided by their core broker, yet 77% of respondents accepted the need for their broker to use outsourced services.
However, Tabb Group’s Healey contends that the need to find new sources of revenue to help counter the sell-side commission pool drought may be more dangerous than the need to cut costs. Some of the larger bulge-bracket firms have begun offering their research to a wider client audience, she says – a move that has inadvertently encouraged customers to turn to rival providers, since the alpha-generating potential of the research is now nullified.
“What’s happening is that buy-side firms are turning to local, smaller research providers for unique insight that the rest of the market doesn’t necessarily have,” she said. “In a smaller pool of participants, each armed with the same information, the opportunity to take advantage of bulge-bracket research is inevitably reduced if it is shared too widely.”
At present, 47% of buy-side firms surveyed use bulge-bracket research, compared to 42% using CSAs to access independent research, according to the Tabb figures. While talk of disintermediation of large financial institutions by smaller firms seems unlikely to become a reality, at least in the short term, there seems little doubt that the bigger picture is changing. Healey believes that commission sharing agreements are likely to grow in importance, as many firms would rather pay a small amount to top up their research when needed than 20 basis points to have it on tap.
Meanwhile, according to Grob, the pressure brought about by changing political circumstances and the difficult macroeconomic environment means that structural changes once seen as temporary are now becoming “entrenched and irreversible” at many financial services firms. In other words, innovation – including unusual outsourcing agreements – is virtually the only protection available to financial services firms seeking to preserve their businesses.
“A unique source of value today may very well be a commodity service tomorrow,” he added. “Like blocks falling in a game of Tetris, the arrival and integration of new sources of value can and should push the old differentiating factors below the line into the realms of commoditisation.”