Stock research gains, e-trading slips in shift

Tuesday, June 21, 2011 Stamford, CT USA — U.S. institutions made two notable changes to their domestic equity trading practices last year:

  1. Institutions reversed a long-term trend in U.S. equity markets by cutting back on the amount of trading volume executed electronically and increasing the share of their trading business executed via traditional "high-touch" trades facilitated by broker sales traders.
  2. Institutions increased the share of their overall brokerage commission payments used to compensate providers of research and advisory services.

The reason for these shifts: A surprise decline in trading activity that reduced the amount of commissions paid by institutions to brokers on trades of U.S. stocks. Brokerage commissions paid on trades on U.S. equities by the 525 U.S. institutions covered by Greenwich Associates in its most recent U.S. Equities Study decreased 12% from Q1 2010 to Q1 2011 to an estimated $11.55 billion. This decline was unexpected: institutions entered last year expecting the commission pool to grow by about 15%.

Institutions use commissions to pay for sell-side research and services used by their analysts and portfolio managers in their investment process. Institutions' demand for these products and services is generally "sticky," meaning that buy-side investment professionals require these items regardless of whether markets or trading volumes are up or down in a given year. As a result, when the amount of commission dollars generated by an institution declines, the institution must adjust the allocation of its trading business and commission payments to ensure that providers of essential research and services get paid.

Institutions Devoting Bigger Share of Commissions to Sell-Side Research
From 2009-2010, institutions used 53% of commissions paid to brokers on trades of U.S. equities to compensate providers for research advisory services, including product and analyst service, sales coverage and the facilitation of direct access to company management teams. In 2010-2011, that share jumped to a 10-year high of 59%, with the remainder used to pay for trade execution services and broker capital commitment. This allocation shift helped institutions keep the total amount spent on U.S. equity research at approximately $6.8 billion, down only 2-3% from the $7.0 billion in commissions spent on sell-side research and services in 2009-2010.

E-Trading Pull-Back
Institutions also acted to maximize the amount of commission "currency" available for the purchase of sell-side research and services by cutting back on their use of low-cost electronic trading systems in favor of traditional "high-touch" trades facilitated by broker sales traders. From 2010-2011, electronic trading channels captured 34% of institutional trading volume in U.S. equities, down from 38% from 2009-2010. Only one type of electronic execution channel held its ground in terms of trading volume last year: algorithmic trading. "There is no doubt that institutions remain fully committed to electronic execution as a means of lowering costs, and we expect institutional trading volumes to begin flowing back to e-trading systems when volumes pickup," says Greenwich Associates consultant Jay Bennett. "But the shift back to traditional high-touch (and higher cost) trades last year shows just how essential sell-side research/advisory services are to the institutional investment process."

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