Leading broker-dealers in the cash equities business have defied the stark doomsday predictions of a few years ago. Yet new research by McKinsey highlights how fragile their activities have become. The Global Capital Markets Survey,¹ for example, demonstrates that the overall recovery in equities trading is being driven by derivatives, financing products, and greater principal risk taking. A separate survey of buy-side equity traders confirms that cash commissions are falling fast. A number of forcesÑamong them, the introduction of new market transparency rules, the escalation of a technology Òarms race,Ó and the unbundling of execution from researchÑare pushing the industry toward an uncertain end state.

While pessimists will undoubtedly continue to predict a rash of new exits, we believe that scale economies, reputations, and privileged pools of liquidity provide the foundation for many sell-side players to stay in the game. Sell-side participants must identify the challenges ahead and take appropriate steps to overcome them.

Rescued by the bull . . .

In 2002, most industry commentators announced the death of the cash equities business. As margins collapsed and new issues stalled, many broker-dealers made dramatic cuts in their equities staffs and merged their equities activities into more profitable fixed-income businesses. A few, including ABN Amro, pulled out of equities altogether in the United States.

During the recent turnaround, the top ten global equities leaders reported overall trading revenues of $36 billion on value at risk of $298 million for 2005, with even stronger results coming through in the first half of 2006. These numbers show that the aggregate volume of cash commissions advanced over the period, albeit marginally. But as results for the third quarter of 2006 show, celebrating the revival of cash equities would be premature.

In a recent buy-side trading survey conducted by McKinsey and the Trader Forum, we found that even the smallest buy-side participants had enjoyed a 12 percent reduction in cash commissions while the largest firms saw commissions drop by more than 30 percent in one year. The decline was most acute in agency baskets, where commissions plunged by a third in one year, and in algorithmic and direct market access (DMA) execution, where there was a 23 percent drop (Exhibit 1).

In addition, while there are some notable exceptions, proprietary trading in cash equities has become relatively unexciting for many players. In 2003, it could generate Sharpe ratios of 6 or higher, but pricing transparency and program trading have reduced the broker-dealersÕ information advantage and cut ratios in half or worse.

. . . but buffeted by growing pressures

Regulation, technology, new buy-side behavior, and fresh competition are the main factors exacerbating conditions in the cash equities secondary markets, thereby intensifying pressure on the profits of broker-dealers.

Regulation

New transparency rules are leveling the playing field shared by broker-dealers, major exchanges, and other market participants, thereby limiting margins. In an effort to promote best execution, the new Regulation National Market System (NMS), in the United States, will increase pretrade price transparency and prohibit trade-throughs (orders executed at prices inferior to those displayed in other markets). Although major exchanges will usually display the best price, market participants will strive for Òtop of bookÓ by shifting some trades to regional exchanges and new venues (for example, Direct Edge ECN and NexTrade). Across the Atlantic, the European UnionÕs Markets in Financial Instruments Directive (MiFID) will promote best execution by fostering competition among broker-dealers, exchanges, and other trading facilities (for example, Project Turquoise, the new pan-European Coalition of leading broker-dealers). Moving to best execution on internalized trades for captive clients will narrow margins. Both new Regulation NMS and MiFID imply higher systems costs to manage across trading venues and meet reporting requirements.

In Europe, official moves to unbundle research from execution are shedding new light on the cost and quality of trading. Like the United KingdomÕs Consultation Paper 176, in 2003, MiFID will do away with the concepts of product bundling and soft commissions and subject each sell-side product to independent valuation scrutiny. While the US Securities and Exchange Commission has yet to follow in the European regulatorsÕ footsteps on this issue, global broker-dealers and global investors are already shifting their business practices toward the new European standards.

Technology

Client connectivity, direct market access, and program trading created a virtuous cycle of sticky client relationships and cheaper and better execution for early movers. That cycle is now much more fragile. Even as electronic communications networks aggregated liquidity, crossing networks and dark pools² have fragmented it. In recent research, McKinsey found that the top eight global equity leaders each spend around $100 million every year on flow equities trading technology. The money is focused mostly on platform consolidation, algorithmic-trading expansion to improve tradersÕ efficiency (for example, portfolio shortfall strategies), the addition of access to all pools of liquidity (crossing networks, internalization), and regulation and compliance with new Regulation NMS and MiFID. Yet as the functionality gap narrows and architectures become more open, client loyalty and stickiness will become more elusive.

Buy-side behavior

On top of these pressures, sophisticated buy-side customers are doing everything they can to achieve best execution at the lowest possible cost. According to a recent buy-side equity-trading survey by McKinsey and the Trader Forum, the average equities buy-side trader reduced the number of active relationships from 70 in 2004 to 62 in 2005. Furthermore, in 2005 60 percent of participants did more than 60 percent of their business with their top ten brokers, up from 47 percent only a year earlier. And just as the equity buy side is concentrating its business on fewer traditional broker-dealers, it is adding relationships with new players that can offer lower execution costs. Electronic communications networks and alternative trading systems now handle around 10 percent of all trading volume.

In addition, the buy side is using order-management systems to understand and optimize the trading flow before revealing it to broker-dealers. Our research found that 95 percent of US buy-side equity-trading desks have been enabled for such systems, while 73 percent use pretrade compliance and portfolio monitoring. Most use transaction cost analysis and are factoring the results directly into how dealers get paid.

New competition

In what appears to be both a direct and indirect threat, the major exchanges are building, buying, and integrating a host of new trading features designed to maximize their appeal to the buy side. Nasdaq built its own Òvirtual book of liquidityÓ as a result of its integration with Brut. INET provided Nasdaq with a trading platform that improved the quality of execution and increased limit order interaction and speed. The NYSEÕs hybrid market structure will allow investors to choose between an electronic Òfast marketÓ and the traditional floor-based model. With the acquisition of Archipelago, the NYSE took over industry-leading smart order routing, as well as automated and transparent opening and closing auctions. Its subsequent acquisition of MatchPoint Trading provided the complex functionality that portfolio managers need when they use the Portfolio Crossing Service (NYSE ArcaÕs after-hours crossing facility).

To get the deals done, the NYSE had to dispose of ArcaÕs WAVE Securities brokerage, and Nasdaq had to dispose of the Instinet brokerage. Looking ahead, however, more direct buy-side access to exchanges seems likely. Already, the NYSEÕs floor brokers do a brisk business representing hedge funds without the involvement of any broker-dealer. Further, Euronext exchanges permit buy-side institutions to become direct members. It may soon be time to examine the rules governing membership in buy-side institutions on US exchanges.

When to trade

Given the regulatory, technological, and competitive forces at play, observers might easily conclude that a mass exodus is imminent. After all, why should generic me-too execution capacity remain in the market?

But winner-take-all solutions are just as elusive in cash equities as in steel or any other commodity, so we expect a whole slew of players to remain. At least one of four justifications exist for continuing as a sell-side participant in cash equities.

1. Scale economies. A few cash equities trading houses will stand out by combining superior functionality and lower costsÑa combination that is possible only with scale. The best will borrow ideas and technology from liquid-rates markets, consumer finance, hedge funds, and even manufacturing to create a robust, industrialized business model in which very few people play much higher-value roles.
2. Protected pools of liquidity. Many country markets, especially in Asia and Europe, will remain opaque as a result of differences in governance and reporting practices. They will continue to nurture Ònational championsÓÑplayers with local insight and protected pools of liquidity.
3. Reputation. Except for the most sophisticated players, issuers will have difficulty comprehending a broker-dealer that does not trade stocks. Sell-side participants will have to retain a right-sized business as a necessary capability, just as it is not unusual to see low-profitability foreign-exchange and government bond trading desks in most fixed-income trading environments.
4. ÒMean reversion.Ó The good old days might return: as Michael Scotti puts it,³ the Òdying art of human block tradingÓ might make a comeback. Through sophisticated pricing and management of risk, banks can offer clients a compelling block trading capability, while generating incremental principal revenues.

Levers for success

As traditional broker-dealers seek to counteract the pressures bearing down on them and to capitalize on the opportunities that still exist, they need to examine most areas of their business. A majority of players are already acting on one or two, but few are pursuing all the avenues available to them. For those determined to stay in the game, we see seven possible courses of action, some revenue enhancing, others efficiency generating: (1) lock in nontraditional trading flows; (2) get the most from best execution; (3) stay ahead of the buy side in algorithmic trading; (4) find the next-generation trade-processing model; (5) reinvent research; (6) rethink the go-to-market model; and (7) develop more sophisticated segmentation techniques.

Lock in nontraditional trading flows

Goldman Sachs (REDI Plus), Citigroup (Lava Trading), and Bank of America (InstaQuote) have all expanded their client order flows by acquiring and integrating leading third-party market connectivity providers into their in-house offerings. As a result of UBSÕs landmark agreement with Charles Schwab, more than 90 percent of SchwabÕs volumes go through UBS. MerrillÕs participation in Investment TechnologyÕs (ITG) crossing network, Block Alert, represents the next wave of collaboration between broker-dealers and other pools of liquidity. Broker-dealers need to extend their reach into buy-side order management and alternative trading venues so they can maximize control over trading flows and hedge their bets on the industryÕs evolution. Through its recent strategic partnership with Portware, Merrill Lynch is hoping to win and retain its customers by providing access to its algorithmic platform and full suite of proprietary data and analytics through an open-architecture, broker-neutral interface.

Get the most from best execution

Leading players will try to compete with and disintermediate the major exchanges as a way of offsetting the lower trading economics and higher costs (for instance, order routing and data management) of the new Regulation NMS and MiFID. In the United States, the largest equity houses will take advantage of their greater pricing transparency to internalize more liquid flows and substitute their dark pools (such as GoldmanÕs Sigma X and UBSÕs Price Improvement Network) for trades in the exchange upstairs market (Exhibit 2). The largest equity players have also started taking aggressive positions in regional exchanges: for instance, Citigroup, Credit Suisse, Fidelity Brokerage, Lehman Brothers, and Merrill Lynch own a large share of the Boston Equities Exchange, and a consortium led by Merrill Lynch owns 89 percent of the Philadelphia Stock Exchange. The recent launches of broker-dealer-led alternative trading systems like Level and Bids will further enhance the broker-dealersÕ best execution choices. In Europe, where systematic internalizers face losses as they move to best execution, the largest equity houses will form new trading facilities (for example, Project Turquoise) to compete on a more level playing field against regulated markets.

Stay ahead of the buy side in algorithmic trading

Nearly all equity-trading houses use simple trading algorithms such as volume-weighted average price (VWAP), pairs, and mean reversion, thanks to the successful efforts of FlexTrade, Portware, and other vendors. The most sophisticated equity program trading desks are neck and neck with leading buy-side traders in developing the next generation of trading models and rolling out specialized algorithms (for instance, dark book crossfinders such as J. P. Morgan ChaseÕs new Arid algorithm). These desks are designing proprietary models that outthink industry standards (one example: the Òagent-basedÓ approaches that predict typical investor behavior and take contrarian actions). Some are funding leading-edge university research in model theory to get a first look at innovations. However, many trading desks are unsure which innovations to make available to clients and which to preserve for proprietary trading.

Find the next-generation trade-processing model

Since the downturn, several leading firms (notably Lehman) have transformed their middle- and back-office systems and processes for equities to maximize straight-through processing rates. To take trading costs down to the next level, some firms are now borrowing lean techniques from manufacturing, such as eliminating multiple reconciliations by unifying data flows (better balancing throughput across front, middle, and back offices) and eliminating manual handoffs between desks. At one firm that embarked on an end-to-end process-improvement initiative, the number of manual processing steps dropped by more than 30 percent. Most equities players are also rethinking their global operating models by shifting relatively generic functions from major trading securities centers to lower-cost near-shore and offshore locations. Looking ahead, we expect at least one broker-dealer to redesign its approach totally to come up with a disruptive, radically lower-cost model for cash equities.

Reinvent research

A few institutions, particularly Morgan Stanley, can produce reports that clients will pay for with hard cash. Morgan Stanley dives deep into industry sectors with proprietary channel checks, offers a superior valuation tool (ModelWare), and delivers excellent access to company management. By contrast, other institutions have focused on minimizing costs. Goldman Sachs has somewhat reduced its reliance on expensive, high-profile research Òstars,Ó while J. P. Morgan Chase has built a Òresearch factoryÓ to deliver low-cost, basic analytical research from India.

Those with distinctive products will be well positioned to win over client segments that demand and value research. Many midsize and even larger hedge funds with a fundamental approach and limited staff recognize the value of superior research and company introductions. Further, many fundamental managers who control substantial assets under management remain comfortable with the traditional model of research sales and full commissions. Sell-side firms that offer distinctive client-tailored research can develop meaningful intellectual partnerships with tough-to-serve managers.

Rethink the go-to-market model

Several equity leaders have redesigned their distribution models, substituting market-informed sales traders for traditional research salespeople. Goldman Sachs, for instance, has decided to concentrate special attention on the large and growing segment of hedge fund complexes that need top-quality sales-trading coverage and have little or no use for research sales-people. Whereas research sales offer diminishing value to the buy sideÑand are difficult to scaleÑsales trading is exactly the opposite: as a sales trader does more business in a given stock, he or she needs to do less work to have a valuable perspective for the next client.

Develop more sophisticated segmentation techniques

Nowadays, it is common practice for leading equities traders to segment their clientsÑby sophistication, size of wallet, or use of resources (research, salespeople, capital)Ñand to differentiate the services they offer each segment. While this approach is a step in the right direction and a precondition for success, it no longer suffices as clients increasingly look and act like counterparties. To stay ahead, institutional-trading houses can learn from American Express, Capital One, and other consumer credit leaders about dynamic, data-driven customer-management systems that prompt outbound offers based on customer spending patterns and credit status. The best equity-trading houses will soon have systems that can monitor their clientsÕ trading behavior (routing away, liquidity provision, information value, and so forth) and suggest appropriate responses to sales traders. Already, the best shops offer special treatment to their most loyal clients (for example, suggesting new trading ideas and allocating greater capital for block losses on illiquid stocks).

Insiders know that the recent explosive growth of derivatives and new markets conceals the weak fundamental position of cash equities. Strong volumes cannot sustain the business indefinitely. Yet there are many reasons to stay in the business. Firms need to decide whether they will, and if they do they must restructure and reinvigorate their sell-side activities accordingly.