The Midtier: Betwixt and Between

Being stuck in the middle is challenging. Large firms have size and reach. Small firms have flexibility and low overhead. What does the midtier broker have? Unable to process at razor-thin margins, quickly develop and market differentiated trading solutions, or support greater loss ratios, many midtier brokers are trying to determine their value proposition in a sub-four-cent-per-share commission market.

Advanced trading technologies are making it more difficult than ever for the midtier to compete with the bulge bracket. Midtier brokers are having trouble justifying the $20-million-a-year spend needed to develop a sophisticated algorithm suite to keep up with the large brokers. As flow moves from high to low touch, firms are seeing a 3 cent decline overall in average trading commissions, from 5 cents to 2 cents - and it takes the execution of approximately 1 billion shares at 2 cents to make up a $20 million investment. This is a high hurdle.

Further, just as past results do not guarantee future earnings, making the investment does not guarantee success - midtier brokers still need sophisticated marketing and distribution plans to gain traction.

And even if the buy-side traders adopt the technology, profitability is not certain. Poor earnings even have plagued large firms over the past few quarters. Not only is the advanced technology expensive, but this technology enables clients to cherry-pick the easiest trades, leaving only the most difficult for the brokers. For these trades, investment managers are asking for capital commitment, which is increasing brokers' loss ratios from 10 percent to 13 percent to 17 percent to 20 percent.

So what is a midtier firm to do? How can it afford to provide an advanced trading desk? How can it not? For midtier firms to succeed, they need to be vigilant across the whole spectrum. First, an advanced trading platform is a necessity. While midtier firms need to be in it to win it, they need to do so without accumulating so much debt that it breaks the bank. While differentiation is important, firms should not wait for the ultimate solution before implementing something. The experience of implementation will help firms better understand the market need.

Second, firms need a seamless infrastructure. As order flow becomes more streamlined and electronic, firms cannot afford to handle the back end manually. Third, a talented trading desk is critical, as the more that it is automated, the more difficult, and potentially more costly, it will be to trade traditional order flow.

The next requirement is a robust service offering that provides customers with a richer and more technologically advanced set of trading personnel - to answer customers' market issues and help them better understand the technology. Many customers also are looking for market insight and are willing to pay for it. Firms need to lock into their high-commission base and leverage it. While midtier firms can't cover the market as a bulge bracket, they should target specific market segments to make them distinct. While the total pool of high-commission dollars is declining, it's there - but firms need the research and IPO calendar to justify a higher commission base.

Finally, midtier brokers need to diversify their business stream by moving into more-lucrative product sets and customer bases. While commodity products, such as U.S. equity, targeted at investment managers have been extremely competitive, it does not mean that the derivatives, nonsovereign debt, or structured product markets targeted at corporations and other market segments have been profitless. These markets offer wider spreads and may present more opportunity. However, entering these markets also comes with investment.

While midtier brokers certainly are betwixt and between, they aren't out for the count. Midtier firms - like Legg Mason, which traded its brokerage business to CitiGroup for Citi's asset-management business - may want to redefine their business models, customer segments or product mix. Whatever the case, they need to look at their value proposition and redefine how they operate in a significantly lower-margin world. While speed has defined the way firms manage data and trade, business flexibility and speed soon may define how firms compete and if they survive in the new, advanced-trading world.

Larry Tabb is founder and CEO of Westborough, Mass.-based Tabb Group, a financial markets strategic advisory firm. [email protected]