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March 23, 2010

Why New Regulations Will Help the Big Brokers

"That which does not kill me makes me stronger." So wrote philosopher Friedrich Nietzsche in 1888, less than a year before collapsing in the streets of Turin and then not dying, but instead beginning a long mental and physical decline. Ten years later, the then-deranged man suffered a stroke, which also did not kill him, but left him unable to walk or even speak for the rest of his life.

Despite Nietzsche's rapid invalidation of his own axiom, it lives on in the popular culture. The concept is inherently flawed for us members of the animal kingdom, plagued by innumerable things that do not kill us but that clearly don't make us stronger, either (Rickets, anyone?). Yet it is a phrase that regulators should keep in mind, because as new regulations are piled up, any that don't completely kill the big brokers will, in fact, make them stronger.

Before I explain why this is so, let's look at the regulatory environment we find ourselves in. One small part of the reaction to last year's financial crisis has been a burst of new regulatory proposals for the stock market unlike anything since the 1930s. While angry bloggers rant about various inequities in equities, senators and congressmen barrage the Securities and Exchange Commission with letters demanding a variety of new rules. 

As a result, there is a baby boom of rules going on. So far, we have new rules or official proposals on naked short-selling, sponsored access, flash trading, dark pool quoting, and the return of the uptick. A little less further along, a variety of new disclosures are gestating in the SEC's womb: new short sale reporting requirements, identification of dark pools on the tape, detailed position reporting for large trading firms and more. And finally, there are dozens of embryonic new rule ideas within the SEC's Concept Release issued in January. Not proposals yet, the 219 questions it contains about market structure topics appear to be a systematic effort to gather ideas from the Street for potential new rules. 

Some of these new proposals seem like sound regulations that will be beneficial for investors, while others may be harmful. Some of these proposals could have a major impact on trading, while others would barely affect the markets. But whether good or bad, important or trivial, all of these will have a material secondary effect: They will raise expenses for broker-dealers. 

New rules, no matter how trivial, are not cheap for brokers. Firms need to pay for lawyers to study and interpret the new rules, technology teams have to implement system changes and buy hardware or third-party services, and traders and salespeople need to be educated. And that's the relatively cheap part--the big cost is that the firm needs to deal with the new rule and monitor compliance with it forever after. In its cost-benefit analysis of the new uptick rule that was announced in late February, the SEC estimated total implementation costs for the financial industry at the staggering sum of $1 billion, with ongoing maintenance costs of another $1 billion per year, in perpetuity until the rule is someday killed off. With many more new rules on the way over the next several years, individual broker-dealers should expect their ongoing compliance costs to increase by millions of dollars a year. 

So what's wrong with that? Why should anyone care about raising costs for a bunch of Wall Street fat cats? The reason policy-makers should give this thought is because higher compliance costs change the economics of Wall Street and will drive trends that may not have been intended. Spending money on compliance is not optional--brokers that choose to stay in business need to spend whatever it takes to comply with all the rules.  Therefore, compliance, like rent or computer servers, is a fixed cost. 

As I learned in my freshman economics class, the level of fixed costs in an industry and the ability to leverage these costs across volume ultimately determines the competitive landscape of any industry. Industries with low fixed costs have low barriers to entry and end up with thousands of independent small businesses. The Census Bureau estimates there are more than 85,000 independent barber shops in America. Why should a talented barber give a cut of his hard-earned revenue to someone else, when he can open his own shop with a chair and a pair of scissors, and keep most of the money for himself? On the other extreme, industries with high fixed costs end up with a handful of giant firms, as the need to drive massive volume through the high-cost platform leads to consolidation. That is why there are currently only two major U.S. tire producers, and a total of only five globally.

Historically, stock trading has been much closer to the barbershop model than the tire model. Fixed costs were low, and like barbers, talented brokers frequently split off to start their own shops, resulting in thousands of small broker-dealers throughout the nation. But as the drumbeat of regulation quickens, remaining in business requires an army of lawyers, a platoon of compliance personnel and a roomful of expensive hardware. As fixed costs in the brokerage industry grow, economics dictates that we will see consolidation and fewer independent broker-dealers.

So is there any evidence in the real world that this is happening? In 2003, according to FINRA, there were 5,392 registered broker-dealer firms in the U.S. That number has dropped every single year since then, to 2009's number of 4,750. As decimalization, OATS, Reg NMS and other rules kicked in, we saw a net 642 broker-dealers shut their doors, or a net decrease of 12 percent in the number of brokerages in only six years. While the pace of new regulations ramps up, consolidation will ramp up, too, and so I expect that the total number of broker-dealers will plummet over the next decade.

But for big broker-dealers, complicated new rules are a good thing. A few million dollars in additional costs may barely change the average per-share costs when spread out over billions of shares traded, while the same increase in costs can devastate the economics of a small firm. Increasing everyone's fixed costs across the board raises barriers to entry and prevents new firms from forming, squeezes small shops out of the industry and allows the biggest firms to increase their market share and better leverage their platforms. 

The more rules that pass, the more reporting requirements that are created, and the more mandatory overhead that piles up, the better the competitive position will be for the biggest shops. So while small brokers may suffer, for the big shops, Mr. Nietzsche's axiom applies: Any new regulations that do not kill them, will make them stronger.

 

Dan Mathisson, a Managing Director and the Head of Advanced Execution Services (AES) at Credit Suisse, is a columnist for Traders Magazine. The opinions expressed here are his own, and do not necessarily represent the opinions of the Credit Suisse Group.

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