Boiling a frog on the capital market

The boiling frog story is an anecdote describing a frog slowly being boiled alive. The premise is that if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death. In this blog post, I will argue that brokers on the capital markets have to watch out because the heat is on with decreasing revenues and increasing costs. In my opinion, banks and brokers have three options with their capital market offerings; use trading to cross-sell, re-vamp the value chain or exit.

Dwindling fees and value propositions

The volumes on the stock markets have decreased during the last five years. It is most evident when looking at the monthly turnover on the NasdaqOMX stock exchange where the monthly turnover has been reduced from 400 to 200 billion SEK. True, most of the decline can be attributed to the emergence of multitrading facilities (MTF) but it is nevertheless an explanation to the reduced commissions in the industry. Customers equipped with direct market access (DMA) have successfully squeezed the stock brokers to slash fees. The commission is now a tenth of the rate I was used to when I was in the industry twenty years ago. The institutional investors were successful in negotiating the fees already then and have probably been even more successful now when they are equipped with advanced order routing capabilities to automatically find the best price. To add to that, many of the brokers are currently dismantling their own value proposition to institutional clients. New regulations and lessons learned from HQ Bank and other proptraders have brokers to shy market risks and thereby limiting their placing power to their large institutional clients. Similarly, most brokers realize that the cost performance on research is challenged, especially if you are not ranked as one of the top three on the market. But the retail market is no haven. Nordnet, an internet broker with strong retail focus, reported in their latest annual report that the net interest income exceeded the net commissions in 2011 for the first time ever.

The cost creep

We have seen a steady increase in the costs on the sell-side on the capital markets. Contrary to common belief, it is not due to lavish expenditures or ridiculous compensation schemes. No, this cost creep is due to new regulations, aggressive product development and increased connectivity. The compliance fury is reaching new all-time-highs every year. When compliant with MiFID, Basel II, UCITS and FATCA, it is time to make additional investments to ensure adherence to EMIR, the new regulations on OTC-trading.

The industry has been aggressive in developing new products, especially capital-protected investment opportunities. In addition, the banks have to ensure that they support the new accounts, IPS and ISK, which the government is promoting to give investors the chance to manage their capital taxes. All this products tend to have some quirks that require some adjustments in the back-office processes and systems. What might seem like a minor change to the marketing department may ripple through hundreds of legacy systems and drive IT-costs beyond reason. But, it is not the initial investment to adjust the system to the new products that is the problem, but the added complexity in the application logic that drives maintenance costs. In addition, there is a substantial opportunity cost given that most banks already devote 70% of their IT-budget on operations and maintenance and thereby find it hard to allocate funds to projects that generate growth. There is an element of Catch-22 to this situation too. The complexity of the systems is never reduced and when banks try to replace them they find that the new system doesn’t support the quirks of an old product that is held by some customers.

Connectivity has raised the cost of doing business on the capital markets. Now days, all retail investors expect their brokers to provide eTrading through the web and mobile devices with real-time quotes to all markets. The institutional clients expect the broker to provide system-to-system connectivity so that orders can be routed automatically for instantaneous execution, allocation and settlement instructions to be received electronically and research to be published to external distributors. And we know for sure that the connectivity requirements will not decrease in the future. Neither will the costs.


I hear war stories about the increased cost awareness in the industry where brokers no longer are equipped with cellphones by default and the number of market data terminals is challenged and consolidated to fewer vendors. It is evident that the new normal has affected the brokers too. But, personally, I have to say that I do not think that these measures are adequate to reverse the margin squeeze that the industry faces now. I think that we have three alternatives, each with their own challenges:

  • Accept current state and cross-sale other, more profitable, offerings

There are lessons to be learned from Nordnet where the net interest incomes exceed the commissions. Banks have for a long time used the mortgages as a hook product to acquire new customers. They use the insight into the customer’s economy to find ways to cross service and increase their wallet share. Lately, we have seen several stock brokers that re-position themselves as Private Bankers. It may be viable strategy assuming that it is based on an understanding of their customer base. Are the clients predominately delegators or validators? If they are soloists, you will most likely lose the majority of your customers in the transition. In addition, you will have to consider your skill mix, branding, culture and compensation schemes in order to succeed with the migration.

  • Re-vamp the value chain

A bank estimated the cost for a plain vanilla transaction from order to trade confirmation to roughly 100 SEK. Given the high level of straight-through-processing (STP), you can assume that only 5% of these costs are truly variable. Given the cost structure, it is evident that you should challenge the costs, value and level of STP in the supporting processes. A traditional Active Based Costing analysis can probably help in identifying the potential in addressing the true cost drivers. Based on my experience, there are still opportunities to leverage IT to streamline the management of corporate actions, reconciliations and reporting. But, in the end, this boils down to economies of scale. And, if you cannot increase the volumes yourself why not consider outsourcing?

  • Exit

I started this blog post with the anecdote about how to boil a frog. I think that it is evident to everyone in the industry that the temperature is increasing at the same pace as the margins are decreasing. The question is when you will exit to ensure that you do not get cooked. Please rest assured that the Capital Market will remain like this. This is the new normal. We will not experience any new hay days as during the eighties.

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