In the past five years, Milwaukee-based investment bank and brokerage Robert W. Baird & Co. has almost doubled the size of its research division, expanded sales and trading into New York and London and completely rebuilt its trading room. In late September, the firm expanded into program trading. In the coming months, it will start to build its own algorithms.
"We’re excited about building out program trading," said Dan Renouard, Baird’s chief operating officer of institutional equities. "Broadly speaking, we’re focused on building out our electronic executions offerings, as well. There’s going to be a lot more coming from us in the next three to six months."
Behind the moves, according to Baird executives, were client demand, low-cost technology and a surplus of talented ex-bulge-bracket employees looking for work. The result has been an expansion by the firm that has elevated its profile from a regionally oriented shop into something more akin to a full-service bulge bracket firm.
Baird is not alone. Firms such as Piper Jaffray & Co., Raymond James & Associates, William Blair & Co., Stifel, Nicolaus & Co. and others have also spread their wings in recent years, far outgrowing their regional rubric and garnering reputations as talented national firms that happen to specialize in small- and mid-cap stocks. While they may still underwrite local municipal bonds, finance companies in their own backyards and service retail customers in concentrated areas, their institutional customer base has grown, along with their offerings.
Outside the Region
Over the past five years or so, the mid-tier trading desks have been reorienting their roles in the market. They aren’t the capital, product and service-heavy behemoths of the bulge bracket. They’re also not the narrowly focused, institution-only specialists of the boutique mold. And they’ve moved far outside their original "regional" coverage areas.
During this time, they have extended their execution business across the country, even overseas. They’ve been offering more products and services, including bulking up their electronic execution capabilities. And following the disruptions in the marketplace last year, they’ve been adding experienced pros from the largest investment banks to their trading desks and research ranks, looking to enhance their execution quality and expand their coverage.
But none of these firms changed to be fashionable. They’ve changed because they had to, if they wanted to increase their chances of getting paid. Industry trends had been moving away from a payment model where mid-tier brokerages more or less had to be compensated in flow for their research.
And they’ve changed because they could. New lines of business became more accessible as more sophisticated trading technology became more affordable.
The Baby Bulge
"We need to be able to continue to evolve with how the buyside is changing the way they pay people," said Jim Fehrenbach, Piper’s head of equity distribution. "We do that by adding products and capabilities. And really, the most important part of that process is adding the right people."
And their customers have noticed. Cheryl Cargie, head trader at Ariel Investments, a small-cap firm in Chicago with $4.8 billion in equities under management, said the group picked up good traders. She also gets more attention from some of their traders, and generally likes her coverage with them better.
"A lot of [regional sales traders] come from the bulge bracket. They do the same thing," Cargie said. "They’re great at working orders, shopping order flow. I see no difference."
In short, they may come to resemble baby bulge bracket firms. But the bulge model is one these mid-tier firms are trying to borrow from to make selected gains in market share, not become, said John Feng, a consultant with Greenwich Associates.
"My general sense is these firms are not necessarily trying to aggressively build themselves into a bulge bracket firm," he said. "Generally speaking, they are trying to make smart hires, beef up selected areas, paying close attention to the profitability of their actions. These firms are placing more emphasis on the trading side to ensure they are collecting adequate market share from the trading or commission perspective."
Where Business Has Moved
Placing more emphasis on trading means expanding products and services. And this could mean opening offices overseas, as Baird, William Blair, Stifel, Piper and Raymond James all have. It could mean building algorithms, as Stifel has and Baird will soon. It could mean adding a high-yield bond desk, as Stifel has, or a convertible bond desk, as Stifel and Piper have. It could mean starting a commission management business, as Piper did. Furthermore, it could mean integrating a global platform, as Piper is: joining all of its products and cross-selling them throughout its U.S., European and Asian desks.
"They want to be responsive to clients and to not turn away business," said David Polen, a senior vice president of hosted product marketing at vendor Fidessa. "And business has moved into global trading and into other asset classes."
With changes like these, and others, former regionals have expanded their model. Regional firms typically started off in the retail space and then moved into institutional. The normal trajectory, according to those following the space, began with firms doing investment banking, then adding research and then trading. It concentrated on cash equities–with a small- and mid-cap bent–and encompassed a full-service model on the institutional side that spans research, sales trading, underwriting and banking coverage.
But today the very definition of a regional broker is complicated, said Dan McMahon, co-head of institutional equity trading at St. Petersburg, Fla.-based Raymond James. Many firms in the space prefer a different rubric.
"I’m not really sure I buy the whole ‘regional broker’ thing, to begin with," he said. "In this day and age, given the dominance of technology, it’s seamless. It doesn’t matter if you’re in Arkansas, St. Petersburg or Wisconsin."
Others agreed.
"We’re not a regional broker; we haven’t been a regional broker for years," Fehrenbach said. "We have more sales and trading personnel working outside of our headquarters in Minneapolis than we do in Minneapolis. We’re an international investment bank."
The mid-tiers have grown to fit the changing environment. At the start of this year, the outlook for research-heavy shops with trading desks looked ominous. The 2008 annual report at one mid-tier firm said as much.
Lower Commissions Ahead
It anticipated more buyside-handled orders and low-touch trading. Subsequently, it concluded, there would be lower transaction fees and lower commissions. It foresaw a year with continuing pricing pressure for traditional brokerage services and expected less overall volume from a beaten-down institutional customer base.
What’s more, U.S. institutional brokerage equity trading commissions could drop by as much as 25 percent from 2009 to 2010, according to a recent Greenwich Associates study. Institutional commissions, therefore, would be roughly equal to 2007 levels, at $10.5 billion.
In addition to commission trends, client-commission arrangements emerged a few years ago to add to the gloom for mid-tiers. CCAs are a payment mechanism for the buyside that lets it get its research from one firm and trading from another.
Looming CCAs
As CCA use proliferated, many in the industry thought they would ultimately consolidate flow into the bulge bracket and a few others. Consequently, the thinking held, mid-tier firms’ research would be paid more often through CCAs, and fewer would trade with their trading desks. Knowing that the buyside wouldn’t have to send its orders to them anymore was a frightening prospect for the mid-tiers.
But the market dislocation that slammed investment banks and institutions alike in 2008 interrupted that eventuality. Lehman Brothers, which accounted for a large pool of CCA funds, went bankrupt, forcing many on the buyside to rethink the wisdom of consolidating their trading in fewer hands.
Still, CCAs–and the consequent consolidation of institutions’ broker lists–remain. Fortunately for the mid-tiers, clients told Greenwich Associates that they are likely to lengthen their broker lists next year to lessen their counterparty risk, according to Jay Bennett, a Greenwich consultant and managing director.
CCA use is not expected to grow appreciably next year, according to Greenwich Associates’ research. According to its data, roughly half the accounts in the U.S. have CCAs. And 60 percent of the larger accounts do, Bennett said.
But of those buyside firms reviewed for Greenwich’s first-quarter 2009 study, few institutions currently without CCAs said they would elect to use them in the first quarter of 2010. And because firms plan to expand their broker lists, it’s likely that CCA commissions will shrink.
The 2008 market dislocation also presented opportunities for enhancing personnel. Piper picked up a large number of veteran trading pros from larger firms such as Bear Stearns, JPMorgan and Banc of America Securities, among others (see sidebar). And Piper certainly wasn’t alone. So many sales, trading and research pros left bulge bracket firms that most in the mid-tier space got into the act and loaded up on the available talent.
Safer Models
Since June 2008, Stifel has hired roughly 75 people from Bear Stearns, Lehman Brothers, Banc of America Securities, UBS and others in its capital markets group, said Tom Mulroy, its co-head. Stifel’s capital markets group covers fixed income and equity research, sales and trading.
"We have aggressively hired over that period of 12 to 14 months, because so many good people were available," Mulroy said. "We took a rifle-shot approach."
Those at mid-tier say they fared better than the largest banks during the downturn–and subsequently looked attractive to prospective employees and customers alike–because their models protected them from the disruption’s worst effects.
Though mid-tier and regional firms have investment banking operations, they lacked prop trading desks and extensive credit exposure, said John Despotopulos, head trader at Lee Munder Capital Group, an institution with relationships with many mid-tier firms.
The traditional Wall Street business model is essentially investment banking-driven, according to Stifel’s Mulroy. Banking generates huge fees, which support research, sales and trading operations. Unlike many regionals and mid-tier firms, though, Stifel built its model based on research, on information.
Also, the balance sheets of mid-tier and regional banks weren’t as leveraged as those of the bulge bracket. While the largest banks in October 2007 were often leveraged around 30-to-1 or 35-to-1, Fehrenbach said, Piper had a leverage of at most 2-to-1. Stifel was leveraged around 3-to-1, Mulroy said.
"So, we’re not out there leading with capital; that’s a very difficult business," he said. "There are loss ratios involved, and it can be a significant hit to profitability if you’re not careful."
On the other hand, an easy business to enter is the basket trading business, according to a veteran buysider. This is why he is seeing more mid-tier and regional firms enter the program trading space.
Over the past five years, Piper and Stifel started program trading desks. Adding agency program capability is a smart move for these firms, the veteran buysider said. For one, they’re an additional and simple way to get paid, as the trades are generally easier. They also generate a lot of flow, he added. Typical program trades can involve hundreds of stocks and millions of shares.
The volume more than compensates for the fact that their commissions are generally lower than those for high-touch executions. Program trades typically go for 1 or 2 cents a share, the veteran buysider said. And sometimes they go for less.
"There are really low payouts, but lots of flow makes up for it," he said. "It’s easy to do; it’s a layup."
But the demand from customers is there, Baird, Piper and Stifel said. And it’s another way for a firm to differentiate itself, the veteran buysider added. Execute a difficult program–such as a small-cap basket–and more flow will come your way, he said.
"There are some people who think that if you do programs, nobody is going to pay you with the regular orders," he said. "I think that’s shortsighted. As soon as you can offer something else, and do it well, people will see that as a benefit."
Finding Ways to Get Paid
Offering more services and products is possible for mid-tiers because the technology is accessible to them. For example, order management system developer Fidessa said the technology it designed 10 years ago to solve or simplify a significant trading problem for a tier-one firm–such as building a global symbology database–is now available to all levels of sellside clients. Mid-tier firms can operate a global trading business not just because the technology has been developed, Fidessa’s Polen said, but because they can also now afford it.
Ultimately, for the mid-tiers, acquiring more talented staff, offering more products and trading into more markets all come down to finding more ways to get paid for research. They must ask themselves whether the changes have paid off with more order flow. And what kind of flow is it?
One longtime buysider disputes the notion that institutions don’t want to give the mid-tiers hard-to-trade stocks because they believe that many of their desks are inferior to those in the bulge bracket. One thought is that this is a reason why regionals and mid-tiers have set up electronic desks. Algorithms are mainly used for large-cap, easy-to-trade stocks. If the mid-tiers don’t have electronic trading, the thinking goes, they don’t get paid.
For his part, the longtime buysider said this perception wasn’t true. Mid-tier shops his firm works with, such as Baird and Raymond James, have good traders for their stocks.
And this opinion doesn’t square with Stifel’s experience, either. Trading revenues are up, according to the firm’s second quarter earnings statement.
Over the first half of this year, Stifel’s equity capital markets revenue has increased 6 percent from the same period last year, to $103 million. Equities represent about 45 percent of total capital markets group revenues; fixed income revenues led the charge with a 63 percent jump during the first half of 2009.
Seeing Genuine Interest
And on the execution side, the stocks Stifel trades run the gamut. "It’s really across the board; we’ll trade as much Microsoft as we will the more non-liquid tech names," Mulroy said. "If we continue to provide the institutional customers good ideas and good information to help them make investment decisions, they will pay for that research from the trading desk."
The moves at Piper Jaffray have paid off, too, Fehrenbach said. But the picture painted by its most recent earnings statement is more mixed. For the first six months of 2009, Piper’s institutional sales and trading revenues were up 38 percent from the same period in 2008, according to the most recent quarterly statement.
Equity sales and trading represents 49 percent of Piper’s total sales and trading revenues in 2009, and 74 percent in 2008. But for the period, the group was down 8 percent from last year–at $61 million, from $66.5 million. But Piper’s trading revenues are beating Greenwich’s estimate of a 25 percent drop in equities commission dollars for the year.
Similar to Stifel, total sales and trading at Piper were bolstered by a 172 percent jump in revenues from last year that the fixed income sales and trading group saw.
Still, Fehrenbach expressed optimism in Piper’s moves. "We’re seeing a real uptick in business in all of our new product areas," he said. "We’re seeing very genuine interest from our clients."
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