In Europe, as elsewhere, 2000 was a truly spectacular year for equity trading. In France, Germany, Italy, and the United Kingdom, the industry as a whole made profits of €6.6 billion ($6.02 billion).¹ But 2001 was an equally spectacular bust—industry profits in the four countries fell by more than half (Exhibit 1). And the industry’s roller-coaster ride isn’t over. A new study conducted by McKinsey and J. P. Morgan shows that equity-trading volumes could grow by 8 to 17 percent a year from 2001 to 2005 but that revenues and profits may be more elusive unless wholesale equity brokers adapt their businesses to the changing requirements of their diverse customer segments.²

A rising market and new listings alone will increase overall market turnover by 8 percent annually through 2005.³ Will it grow faster? That depends on trading velocity: the rate at which investors churn their portfolios.⁴ During the second half of the 1990s, it increased steadily thanks to new trading and order-handling technologies, falling transaction costs, and volatile share prices in a growing market. In 2001, it fortunately stayed flat—if it had dropped as far as market capital did, trading volumes would have fallen much further.

What happens next to trading velocity hangs on changes in demand within market segments and their relative size. Broadly speaking, wholesale brokers serve four customer segments: hedge funds; large active institutional funds and small active institutional funds, both of which pick equities with the aim of outperforming the market average; and passive investment funds (such as index funds), which aim only to mirror the average performance of the equity markets. Although average turnover velocity was approximately 80 percent in 2000 and 2001, the trading velocities of these segments vary a good deal around the mean. A hedge fund, for example, turns over its whole portfolio an average of five times a year, while passive investors typically churn only 15 percent of their holdings annually.

By conservative estimates, overall trading velocity is likely to grow by just 1 percentage point from 2002 to 2005. Although pension funds and insurance companies plan to increase their holdings with high-velocity hedge funds, investment in low-velocity passive funds is also expected to increase substantially, so the velocities of the two will largely cancel each other out. But trading velocity might easily increase faster—more managers of large active funds may make greater use of new systems for handling orders, say. If trading velocity matches its growth rate from 1995 to 2001, total equity market revenues, including those from new capital and new listings, could rise by as much as 17 percent a year until 2005.

In contrast, overall profits are unlikely to rise proportionately. The revenue margins of the trading services offered by brokers differ a good deal (Exhibit 2). While there has been little downward pressure on margins for particular services, investors have shifted a lot of capital to lower-margin ones such as portfolio trades (the simultaneous purchase and sale of a collection of stocks) and bulk trades (which command price discounts) of liquid stocks. This trend, which may well have reduced wholesale-trading margins by as much as 15 percent from 2000 to 2001, is likely to continue as passive or almost-passive investing becomes more popular and trading technology improves (Exhibit 3).

How can an individual broker maximize its share of future profits? The outcome depends on how well it adapts its services to the particular needs of each client segment. Most brokers still try to offer the full service: equity research across sectors and countries and the execution of trades in domestic and foreign equities. But not all segments need the whole bundle. Most large active investors, for example, do their own generic research, so they want only customized research from brokers. Small active investors, however, value any kind of research available to them, while passive investors want only superb trade execution and almost no research at all. Given the general shift to lower-margin transactions, all wholesale brokers should consider moving toward relationship pricing—working out the value of every service they offer each client and pricing it accordingly—rather than billing clients trade by trade. All brokers could also work harder at cross-selling the more lucrative services, such as derivatives and prime brokerage, to their clients.

Besides these "musts," most European wholesale brokers and their parent banks face difficult strategic choices. Companies offering full brokerage services must invest in complex trading systems and hire skilled people, thereby running up huge fixed and semifixed costs. Only global brokers, on the scale of Morgan Stanley and Credit Suisse First Boston (CSFB), can be sure of sufficient turnover to cover them comfortably. Even during 2000, when stock markets were booming, the cost-income ratios of smaller European broking operations actually ranged from an alarming 75 to 110 percent.

Faced with slower market growth, margin pressures, and institutional orders that are being placed with fewer brokers, most European players need to adjust the scale of their costs and to tailor their offers to the changing needs of the segments they can serve best—in most cases, the same ones their investment-banking businesses serve. Some companies may choose to specialize in individual sectors or in a single country or a single function, such as the execution of trades. For other companies, the best option might be to sell their cash-equity trading operation to a global broker.