Buy-Side Shifts Commissions to Pay for Research

Most of us who follow the institutional trading space in U.S. equity markets assume that electronic executions are rising at the expense of the high-touch business. Think again. What may be counterintuitive is the new reality.

Greenwich Associates released results this morning of a study showing that U.S. institutions have been cutting back on the amount of trading volume executed electronically, and raising the share of their trading business executed through traditional “high touch” trades facilitated by sales traders.

Institutions also increased the overall brokerage commission payments to pay for sell-side research and other advisory services.

The surprising results are based on a study of 525 U.S. institutions, marking the reversal of a long-term trend. The reason for the shifts are the “surprise decline” in trading activity which has left the buy side with lower commissions paid to brokers for equity trades, says Greenwich. In its most recent study of 525 U.S. institutions, commissions paid on trades for U.S. equities declined 12 percent from Q1 2010 to Q1 2011 to an estimated $11.55 billion, Greenwich said today. This decline was unexpected, writes Greenwich in a press release summarizing the full report, because institutions entered last year expecting the commission pool to grow by about 15 percent.

[Interestingly, the Tabb Group predicted an even more drastic decline in commissions. According to the Tabb Group U.S. institutional equity commission revenue in 2011 is expected to slip 17% to $7.25 billion. This follows a 21% plunge from $10.58 billion in 2009 to $8.37 billion in 2010.]

With the downturn in equity trading volumes, buy side firms have fewer commission dollars to allocate, and so they are shifting a higher percentage of their commissions to pay for research and other services, including product and analyst service, sales coverage and direct access to corporate management teams.

Buy side firms use commissions to pay for sell-side research and services – i.e., Bloomberg terminals, EMSs, transaction cost analytics – used by their analysts and portfolio managers as part of their investment decision making processes.

So despite the gloom and doom predictions about the decline of sell-side research, when resources are scarcer, the buy- side has chosen to allocate more dollars to research. According to Greenwich, these services are “sticky” meaning that whether volumes go up or down, institutions need to adjust their commission allocations to ensure that providers of essential research and services get paid, stated Greenwich.

Institutions paid 53 percent of their commissions to brokers to pay for research and advisory services in 2009-2010, according to Greenwich. That number jumped to a 10-year high of 59 percent in 2010-2011. The remainder (41 percent) went to paying for trade execution services and capital commitment. By shifting the allocation, institutions were able to keep the total amount spent on research to about $6.8 billion, down only about 2 to 3 percent from the $7 billion spent on sell-side research and services in 2009-2010.

That trend led some of the agency brokers such as Investment Technology Group and Liquidity to offer value-added research businesses to the buy-side.

What seems strange is that U.S. institutions cut back on low-cost electronic trading systems in favor of traditional high-touch trades executed by sales traders. Electronic trading channels captured 34 percent of institutional trading volume in U.S. equities, down from 38 percent from 2009 to 2010, notes Greenwich. The only type of e-trading channel that held its ground in terms of trading volume was algorithmic trading – not surprising since that gives the buy-side control over their executions in a cost-effective manner, across lit and dark venues.

The pull back from etrading however, is not a permanent trend, according to Greenwich, which expects institutional volumes to flow back to e-trading systems when volumes pick up. But for the time being, institutions are willing to pay more for the high touch trades as a way to gain access to sell-side value-added research.