Is Broking Broken?

Technology will bring us a new generation of trader, and those firms that
survive this change will end up being more AI than Square Mile.

Technology is starting to challenge all sorts of intermediation. I don’t use travel
agents, I don’t use an IFA, I don’t use an insurance broker, so where next for
the capital markets broker?

Why should the buy side use a broker? What value does a broker deliver? Will
a broker be able to compete with a technology that can gather, understand
and add intelligence to increasingly huge, complex and disparate data sets and
is able to spot trends in asset classes and individual assets quickly, efficiently
and consistently?

In the past brokers controlled the exchanges. Exchanges were run as quasi-
clubs to support their members. Exchanges had all the liquidity and brokers
were the gatekeepers. By providing investors access to markets, brokers
earned commissions and also received trading fee rebates from the exchange.
A long time ago, brokerage commissions were even fixed. Brokers competed
on the basis of relationships, rather than price. The little black book of contacts
ruled, and individual brokers were worth the strength of their personal
network.

The introduction of negotiated commissions in the U.S. in 1975 taken up by
other markets bit by bit, marked the beginning of constantly increasing
competition and challenges for brokers. In the last 10-15 years, this process
has accelerated. This has changed. Whoever still believes that broking is a
people business is something of a Cnut. The tide is inexorable and it isn’t being
held back.

History confirms this.

Electronic trading turbo-charged trading volumes and liquidity and hammered
the cost of intermediation and broadened access to markets. Access to
liquidity was no longer the prerogative of the members of the club.  Liquidity
spread across exchanges, alternative trading platforms, lit and dark pools etc.
Exchange specialists (market-makers) went away.
Brokers and exchanges are officially divorced and actually compete with each
other in some cases.

With the added burden of MiFiD II regulation, unbundling of research and its
attendant revenue stream, life has become very tough for brokers.
The sell-side securities industry (i.e. the brokers), has been experiencing
deteriorating economics, due to pricing pressures, increasingly stringent
regulation, and changes in market structure.
Their clients – the asset managers, the buy-side, drive demand. The buy-side
itself has been experiencing increasing pressure due to a changing business
mix.

Traditionally, active asset managers, who charge investors significant fees (~1%
of assets under management) and could thus afford to pay brokers full
commissions for full service, i.e. execution and fundamental equity
research, have steadily lost market share to low-cost passive managers.

Passive management – index funds and exchange-traded funds – has been
growing very fast: in the U.S. passive has already captured around 20% of
mutual fund outstanding assets; by now, new asset inflows into passive funds
outstrip those into active funds. Relative to active funds, which is 1% business,
passive funds charge much smaller asset management fees (0.1% basis of
assets for a large cap ETF) and clearly cannot afford to spend as much on
brokerage services. The consequence is pricing pressure for the sell-side, as
illustrated by the declining commission rate on institutional equity trades. At
the beginning of the century, institutional commissions were around 5
cents/share. They are now around 1.5 cents / share, a 70% decline in about 10
years.

So, what can a broker do?

In the past, investment banks role was to ensure that clients’ trades were
executed. Now, the focus is on generating relevant (relevant to the clients’
holdings, interests and proclivities) trading ideas for clients and helping them
decide when, where and with whom to execute the most efficient trade.
Traders have to go up the value curve, becoming more skilled and embrace
technology as a way of complementing those skills. In particular, the winners
will understand something about data, and will sweat every piece of data in
their organisations to deliver maximum value to their clients. Rather than blast
a client base with a trading idea and see if something sticks, the winners will
use data to target clients with ideas and updates that are relevant and timely.

Data, I know, I know it generates a rolling of the eyes and a “here we go again”
expression. But sometimes you have to eat your ugly frog. Just how can people
get a handle on client trading histories, combined with asset trading streams,
combined with watch-lists, combined with some analytics, combined with
news and social media about each asset that’s relevant to each individual
client? Only technology can do this effectively and consistently in the world of
the 3 “V’s” – volume, velocity and variety of data. At LodeStar, we have created
a robot, the LodeBot, so you can embrace the 3 V’s as an invaluable asset. We
are working with many people from small brokers to larger investment banks
and asset managers to make the data work for greater productivity and
profitability. Uses are being discovered for trading desks – the LodeBot is
serving up reasons to talk about an asset which is relevant to a specific client.
The LodeBot is identifying likely buyers and sellers across brokerages. The
LodeBot’s analytics are looking at signals and delivering the probability of
returns or losses over given periods against individual assets. The LodeBot
learns: constantly improving the relevancy of its outputs to each individual
user.

It’s technology’s time to take the heavy data lifting in the world of capital
markets. Brokers that don’t understand this are likely to go the way of the
broker in many other industries. But those that leverage it, are on the verge of
extraordinary success.

About Lodestar: Lodestar is a technology company founded by financial
services domain experts, backed by industry leading software architecture
and development expertise. It has developed Lodebot, a new way of
understanding data to change and improve relationships and profitability in
capital markets.