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November 8, 2005

The Incredible Shrinking Brokerage List

By Nina Mehta

The decline in rates has forced money managers to re-assess their allocations of shares to brokers. Because each share is worth less, institutions are sending more shares (orders) to favored brokers and fewer to others. Money managers are determined to maintain the compensation levels of those brokers whose services they most value. In order to continue to support their favored brokers, they have no choice but to send fewer orders to those brokers on the margins. Greenwich data supports this. The consultant's surveys show more trading taking place, but that the amount of commissions available to pay for research hasn't kept pace. U.S. asset managers had equity investments totaling $8.2 trillion at the end of the first quarter of this year, up 12 percent over the year-earlier period. However, estimated annual commissions on equity trades remained flat at $11.3 billion. Approximately 40 percent of that, or $4.4 billion, is used to pay for broker research and sales.

Low Touch

The reasons behind the shrinking commission rates are several. For one thing there are more low-cost, low-touch execution venues attracting business. For another, the buyside is paying closer attention to best execution. That raises the bar too high for some brokers.

Firms can no longer distribute brokerage commissions as widely and generously as they once did. "The era of what used to be called free commission dollars is out the window," says Peter Weiler, a senior vice president in the investment manager area at Abel/Noser Corp., an agency brokerage that provides transaction cost analysis to buyside firms. "Everything comes down to best execution."

The Trend?

The trend toward lower rates is likely to continue, sources say, as more buyside traders use electronic communication networks, crossing networks, and other low-touch execution options to decrease their costs and limit the potential market impact of their trading.

There is some hope for brokerage firms. One study found that commission rates on high-touch trades of over 120,000 shares are actually increasing. If true, that puts more money in brokers' pockets per trade. The Plexus Group reports that, in 2001, full-service brokers received an average of 3.5 cents a share for large orders. That figure jumped to 3.9 cents a share in 2004. In addition, commissions accruing to agency brokers went from an average of 3.6 cents a share in 2001 to 3.9 cents in 2004. "My suspicion is that the trend you are seeing will continue," Plexus President Wayne Wagner commented.

Despite these numbers, firms are still cutting. One medium-sized manager has cut the number of its research brokers by one-third in the last year. The list now includes between 60 and 70 firms. "Before, we could afford to have a full-service relationship with all the usual bulge-bracket firms," says the firm's director of trading. "But now, with market structure changes, new trading technologies, and our clients' continued diligence in encouraging us to lower explicit execution costs, we need to be more selective. We can't afford to have a $1 million relationship with all 10 bulge-bracket firms anymore." Another change is that three execution-only shops are on this firm's top-10 list of brokers over the last few years.