I’m going to write two posts about the internal trade order-matching network that Blackrock intends to have up and running next year. This one will provide background, some of which I’ve written about before. Tomorrow’s will deal with how the Blackrock network fits as a strategic weapon in the money manager’s arsenal.
three types of commission
For a conventional money manager, commissions paid for trades–or bid-asked spreads, which amount to the same thing–break out into three types, from most expensive to least:
–research commissions, aka “soft dollar” commissions. These commissions consist of a payment to a broker for executing and recording a trade plus an amount to compensate for research services. Ten years ago the research service payment was predominantly in return for information from the broker’s own in-house research. Today, most brokerage house analysts have been laid off and work in independent research boutiques that their former employers act as middlemen for.
The amount paid per trade will depend on the size and trading habits of a given institutional client, by may amount to, say, $.05 per share.
–commissions for execution. These are paid strictly in accord with the SEC mandate for registered money managers to obtain “best price” and “best execution” when they trade for clients. They might amount to $.03 per share, of which $.015 might be the broker’s cost and the remainder a profit element.
–trades through electronic crossing networks, aka ”dark pools” (for fantasy or vampire fans, I guess). These have become increasingly popular. One advantage of such networks is their low cost–maybe $.001 over the expense of executing a trade. The second is their anonymity–you don’t run the risk that your intentions are not only broadcast to your broker’s proprietary trading desk, as they surely are, but also to all the broker’s best customers as well.
attacks on the conventional model
Blackrock’s new trading platform is the latest one. That’s tomorrow’s story.
A second attack, blunted for a while by the financial crisis, is coming from Fidelity and concerns soft dollars.
When I entered the industry, conventional money management firms typically had large cadres of in-house research analysts who serviced the firm’s portfolio managers and reported to a research director. This was expensive. Also, in many cases the firms didn’t have strong enough general management to ensure the in-house research was any good.
As time went on, firms gradually shrank their in-house research efforts. Instead, they began to increasingly depend on analysis generated by the brokerage houses they traded with–paid for with higher-than-normal commissions. This “solved” the management problem. And it had the added benefit of increasing profits by shifting the cost of research away from salaries paid out of the money manager’s fee income to commission expense paid by the client!
How do you justify this, either to the SEC (assuming the agency weren’t clueless) or to clients? The standard response was that this was normal industry practice. How so? …because that’s what the industry giant, Fidelity, does. The mantra has been that if Fidelity allocates 15% of its commission volume to pay for research, it’s ok for everyone else to do that, too.
Just before the onset of the financial crisis, however, Fidelity, which has a large in-house research staff, decided to change its practice. It proposed to the major brokers that it pay them a set cash fee for research each year, say, $8 million.
Brokers balked, for two reasons. The money was been less than they were getting paid before. It would have forced an internal reallocation of compensation away from the traders who run the firms to the researchers who were specifically identified with the fee income.
For other money managers–to my mind, the true target of the Fidelity initiative–this was a nightmare. They could no longer use Fidelity as justification for their soft dollar spending. In addition, their profits would plunge as they either paid out large portions of their management fee income to newly rehired research analysts or to brokers for their research output. Smaller managers might be forced to close up shop.
The soft dollar issue hasn’t gone away. Brokers, however, have “solved” their internal profit allocation problem in the short term by firing most of their veteran researchers during the downturn. And Fidelity seems to have lost interest for the moment in pushing the issue. …or at least publicizing it. It may well be striking cash deals with small research boutiques.
I think Blackrock’s trading platform idea has similar elements of using large market size to damage smaller competitors while at the same time making a profit for itself.