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MiFID, commission-sharing and electronic trading favour large brokers, says Greenwich

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While equity brokerage firms across Europe currently continue to reap the benefits of global stock markets, a series of structural changes threaten the economic prospects of the continent’

While equity brokerage firms across Europe currently continue to reap the benefits of global stock markets, a series of structural changes threaten the economic prospects of the continent’s many smaller brokerage houses and regional firms, according to Greenwich Associates.

In a new report, the 2007 European Equity Investors Study, Greenwich researchers say several trends seem to favour large pan-European and global brokers at the expense of smaller competitors.

The most important developments include the growth of self-directed electronic trading systems and portfolio trading, which require huge upfront investment while driving down equity trading commissions – and thereby broker profit margins.

The report also cites the establishment and proliferation of commission-sharing arrangements that tend to concentrate trading business in the hands of a relatively small number of large executing brokers.

Moreover, the looming implementation in November of the European Union’s Markets in Financial Instruments Directive (MiFID will make it easier for electronic trading systems to establish themselves across national borders and for global brokers and large pan-European firms to compete with country and regional brokers at the local level.

‘Although the markets have been delivering strong returns for equity investors, conditions – while still quite good – have not been as favourable for the sell side,’ says Greenwich Associates consultant John Colon.

‘Average trade commissions are on the decline and the growing electronic trading business promises to shrink them even further. Large brokers are probably in the best shape to adjust strategies, and the arrival of commission-sharing arrangements and MiFID could make it even more difficult for smaller firms to compete.’

European institutions paid their equity brokers approximately EUR5.8bn in trade commissions over the past 12 months, up from EUR4.3bn the previous year. Growth was particularly strong in European, Japanese and Asian equities.

‘The expansion of hedge funds throughout global equity markets is certainly contributing to the pick-up in trading volume,’ says Greenwich’s Robert Statius-Muller. ‘In European shares, and to an ever greater extent in Asian shares, hedge funds’ profile in the equity trading business is growing dramatically.’

Although the institutional trading business is growing rapidly, brokers are making less money on many trades. In particular, commission rates on trades of shares from many of the world’s fastest-growing equity markets, including Hong Kong, Taiwan and Korea, are falling fast. Commission rates on cash agency trades of European shares have been flat at 17 basis points since 2005.

Over that period, however, institutions that have adopted electronic trading have managed to lower their overall blended average commission rate. The average commission rate paid by European institutions on self-directed electronic trades of European shares has fallen from 10bps in 2005 to just 6bps this year, while the average rate on self-directed electronic trades of US shares on the New York Stock Exchange has dropped from 9bps in 2005 to 7bps today.

More than 45 per cent of European institutions have established commission-sharing arrangements with one or more brokers, including more than 55 per cent of the largest and most actively trading institutions in Europe.

In the UK, the proportion of institutions using CSAs has increased to 56 per cent this year from 30 per cent in 2006, while usage in continental Europe jumped from 13 to 35 per cent. Institutions with CSAs direct 37 per cent of all commissions paid on trades of European shares to executing CSA brokers.

Of the commissions paid to executing CSA brokers, 37 per cent is paid out to third-party research providers, 38 per cent is retained by the broker as payment for execution services, and 25 per cent is retained as compensation for research provided by the executing broker.

The significant proportion of total commission payments retained by executing brokers in both regions could represent a real problem for smaller and regional brokers, the report says. Although CSAs promise to aid business for third-party research providers, the data suggests that dealers failing to land deals with large numbers of institutions could see business on their trading desks wither.

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