Remaking market making

There are some who believe that the rise of new, low-cost electronic securities trading should have killed market making and brokerage—the obscure tasks of executing securities trades for customers and matching buy and sell orders, whether on the floor of the New York Stock Exchange or on some trader’s desk deep inside an investment bank. Indeed, commissions have been slashed and bid-ask spreads have fallen; revenue from trading activities has been volatile. Furthermore, the industry has been tarred by trading scandals that have ranged from price-fixing among NASDAQ market makers to the rogue trader who brought down the 232-year-old Barings Bank.
The conventional wisdom is thus that investment banks and securities firms should abandon securities trading and stick to more attractive activities, such as managing assets and originating securities. Investors have hopped on this bandwagon, penalizing banks that earn substantial trading revenue with low price-to-earnings ratios (Exhibit 1).

But is market making and brokerage really such a bad business? Our analysis shows that, despite the gloom-and-doom prognosis, its economics are healthy. The old business model, which relied on manual, ticket-based trading and on fat commissions and spreads, will no longer work. But market making can still be attractive for players that use technology to automate the trading process and gain scale. All banks, whether they choose to compete fully or not, should decide how to position themselves.

Market making revisited

Despite all the bad press, the economics of market making and brokerage compare well with those of other core banking activities, such as underwriting securities and managing assets. Over the past 20 years, trading revenue has grown just as fast as other sources of bank income and been only a bit more volatile (Exhibit 2). And despite declining margins, trading revenue has grown even faster in recent years because of the global boom in securities trading. From 1995 to 1999, market making and brokerage revenue grew at an 18 percent clip annually, slightly faster than the overall average revenue for the whole securities industry. At the same time, the trading of securities accounted for more than half of the total revenue growth for some of the largest securities firms (Exhibit 3).

On the whole, margins in market making and brokerage can be just as attractive as margins in other banking activities. Some banks are realizing a return on equity of well over 20 percent from making markets for traditional cash equities, while margins for more innovative products (such as derivatives) or for the provision of trade-related services can top 40 percent. Compare this with the 10 to 30 percent earned in underwriting and asset management.
Historically, trading volumes surged every time the structure and efficiency of markets improved—for example, the 1986 "Big Bang" reforms at the London Stock Exchange and the 1997 order-handling rules in the United States. So the prospects are good: forthcoming regulatory changes—such as the introduction of single stock futures in both the United Kingdom and the United States—will stimulate the trading of securities by increasing the market’s efficiency and give market makers more flexibility, thereby improving their margins.
In the United States, NASDAQ’s SuperMontage will increase the market’s transparency by introducing a quasi-central limit order book in over-the-counter (OTC) stocks. (The SuperMontage will display three levels of orders or quotes on individual stocks rather than just the best bid and offer, so participants will be able to get a better sense of the depth of prices of and interest in a particular security.) The repeal of the NYSE’s Rule 390 will authorize the off-exchange trading of all listed stocks, thus boosting the market’s efficiency and allowing market makers to match orders internally and to capture both sides of the spread. Decimalization, which was recently introduced on the NYSE and is now being launched in OTC stocks, should also stimulate demand because spreads will narrow, thereby reducing the cost to trade.
In Europe, the changes will be even more far-reaching. The existence of more than 20 separate International Settlement Depositories makes clearing and settlement for intra-European trades three times more costly than they are for US ones. The implementation of a proposal to establish two main clearinghouses would eventually reduce much of that cost and stimulate cross-border trading, but even without this change, the trading of securities is booming among retail and institutional investors alike. European retail investors are diversifying their portfolios of bonds and local equities, taking advantage of new higher-yielding securities and cross-border opportunities. Institutional investors, overly concentrated in local securities, are also diversifying. As a result, from 1996 to 1999 the compound annual growth rate for the trading of European equities (31 percent) outstripped that of the United States (25 percent). We expect this trend to continue.
Meanwhile, the businesses that were supposed to save investment banks—M&A and equity origination—are becoming less attractive. They enjoyed record years in 1999 and 2000, but the sharp devaluation of technology stocks, the downturn in global equities markets, and the slowdown of many economies will all have their effect. In the United States, the telecom and technology sectors accounted for nearly 60 percent of investment-banking activity last year; this level is already falling off as investors question the growth trajectories of these businesses and as companies restructure their balance sheets.

A factory, not a fashion show

Far from killing the business of market making and brokerage, technology will actually save it

If market making and brokerage is an attractive business, why do so many industry players disparage it? The main reason is confusion about the role of technology. Far from killing the business, technology will actually save it. Sure, commissions and spreads are falling, and this trend won’t be reversed. The old people-intensive business model, for the most part, no longer holds. Huge parts of the business—trading in bonds, cash equities, and standardized derivatives—are becoming commoditized. Winning in this environment will require banks to reach unprecedented scale, and a handful of them will take the lion’s share of the profits. But emerging technologies will make competing in this new environment profitable for the eventual winners, allowing them to increase—dramatically—the volume of trades they can process while lowering their costs and increasing their profitability. The leading players will recognize that technology is an advantage, not a threat.
New systems can automate everything from front-end order capture to back-office clearing and settlement. At the front end, new services now enable both institutional and retail investors to enter their trades directly into their brokers’ systems or electronic communications networks (also known as alternative trading systems). Firms process far more trades, and both costs and errors are lower. Bloomberg, Bridge Information Systems, ITG, and Reuters offer such services, and most investors now have electronic-data-interchange links to their brokers.
Technology is also revolutionizing the post-trade process, reducing per-ticket clearing and settlement expenses. Cross-border European trades cost an estimated €28 ($24.90) to settle, compared with only €1 or €2 for settlements executed with more highly automated systems. To automate the back office, financial institutions should look at custodian and clearing banks. State Street, for example, has invested $250 million to $300 million annually in technology for the past five years and can now offer inexpensive back-office services to other firms. Financial institutions must keep an eye on these players, since they are now creeping into the execution of trades.

New systems allow trading firms to match trades internally, thereby capturing the entire spread between the bid and offer price

Paradoxically, technology can also increase margins per trade and improve the ability to manage the execution of block trading. New systems allow trading firms to match trades internally, thus capturing the full spread between the bid and offer price and avoiding exchange fees, though internalization can boost profits only for institutions with enough volume to ensure a high internal matching rate. New order-management software can automatically break up and manage large trades to minimize their impact on market prices, thereby giving the customer a better price and boosting margins in the process. This is particularly useful in portfolio reallocations, which entail the trading of large blocks of many different securities.
Newer technology can also give market makers and brokers a better understanding of their customer base. Banks and securities firms that have always won business by building personal relationships with a few big investors can now use software to determine the profitability and appropriate service levels for a much larger number of accounts. Another new technology will permit trading units to change their service model away from primarily "push" (deluging portfolio managers with the latest research) and more toward "pull," which allows investors to access research selectively and analysts to aggregate and tailor information easily. Multex.com, for example, gives investors access to research from most major institutions. Consortia such as Securities.Hub are making it possible for investors to access, in a single place, the initial-public-offering calendars, research, and other services of leading firms. All of these efforts increase margins per account and may boost trading volumes as well.

Getting to scale

Investing in these new technologies obviously raises the fixed costs of any trading business. Scale, which makes the business more attractive in several other ways, will therefore be needed. Besides lowering the marginal cost per trade, a greater volume of orders cuts volatility and risk. With a larger order flow, an institution can match more of its trades internally, thereby putting up less capital in each transaction and holding a smaller inventory of securities. As a result, there is a clear negative correlation between trading revenue and the value at risk (VAR) relative to trading volume (Exhibit 4).¹ Merrill Lynch and Morgan Stanley Dean Witter, for example, have a much lower VAR relative to their trading revenue than do firms that have smaller order flows. Bigger companies will find trading to be a more stable and profitable business.

In capturing additional order flow, players will also benefit from diversification. Institutional orders from mutual-fund managers, pension funds, and insurance companies are important because of those orders’ size and overall share of the market. But many institutional-investor segments trade infrequently and tend to base their buy and hold activities on fundamental portfolio decisions. Hedge funds are usually more active traders, with average turnover rates that are three or more times the size of their assets, so their order flow can provide valuable real-time information on market conditions. And banks can’t ignore retail customers: smaller trades are easier to execute and more richly priced. Furthermore, small orders (a proxy for retail trades) now represent around 70 percent of all trades executed in OTC stocks, up from 57 percent in 1994. Orders from outside the United States will also be important given the rapid growth of global securities trading.
Increasingly, winning businesses will need to provide services beyond trade execution. Some investment banks, for example, now offer prime brokerage services—all of the back-office and financing services that support a trade—to hedge funds and other players.
A faster way of capturing extra order flow, following the lead of wholesale trading houses in the OTC market such as Knight Trading Group and Spear, Leeds & Kellogg, is to purchase order flow from smaller broker-dealers. Because wholesalers process a large volume of trades, they can often act as the counterparty on both sides of a trade, thus boosting margins. Investment banks have recently bought several of these wholesalers: Goldman Sachs purchased Benjamin Jacobson & Sons and Spear, Leeds & Kellogg, while Merrill Lynch purchased Herzog Heine Geduld. But perhaps this model has been too successful, for few independent wholesalers are now left; Knight is the most important of them.
Acquiring customers in Europe is going to be more difficult for US banks, since European retail investors naturally turn to local institutions, and European bank acquisitions are complicated by large branch networks and strong labor unions. A more promising strategy is to capture order flow through another channel. Morgan Stanley and OM Gruppen, for example, launched Jiway, an exchange where retail investors trade the top European stocks (more than 400 of them at present). Goldman Sachs launched PrimeAccess, a service that provides international-trade execution, research, and some IPO allocations to on-line brokers (mostly in Europe), including Direct Anlage Bank and Banca Popolare di Verona. Merrill Lynch and Credit Suisse First Boston (CSFB) are launching similar services; to this end, CSFB built an alliance with Postbank’s on-line broker, Easytrade, in Germany.

A role for proprietary trading

Many banks abandoned the trading of securities because it has been associated, wrongly, with the scandals of so-called proprietary trading. In the second half of the 1990s, banks often put their own capital at risk to make speculative macroeconomic bets—for example, bets on the direction of interest rates or currency movements. Not surprisingly, the returns were highly volatile, and the shareholders and managers of these banks were sometimes caught off guard.
Such trading has received a huge amount of well-deserved bad press. These activities are essentially no different from what hedge funds do, but while George Soros’s investors are prepared, at least in theory, to stomach huge losses as well as gains, shareholders of blue-chip banks are not.² In recent years such opportunities have been more limited, and the resulting risk of these trades is better left to hedge funds, whose investors can diversify their own portfolios appropriately.
Most major banks have now scaled down these speculative activities, but taking principal positions is a necessary—and potentially lucrative—part of market making. The difference is that such positions are closely related to customer business, not speculative bets. In making markets or executing a large client trade, a bank must often take on some or most of the position for a period and stands to gain (or lose) from price movements during that time. In fixed-income businesses, trading gains (or losses) from this kind of activity can overwhelm spread or commission revenues. Naturally, banks also gain valuable information about market sentiment from market making. They can, and should, exploit this information to manage their inventory of securities efficiently and (if risk limits are observed) to gain from taking principal positions for the bank’s account.³

The sweet spots

Other parts of the trading business will continue to earn higher margins as well. One task that will never be fully automated is block trading, or executing the huge trades that would move prices too much if put into the market all at once. Traditionally, "upstairs" traders break these trades into smaller ones and work them over several days to obtain the best overall price for the customer. Electronic-trading algorithms are replacing some of this activity; trades of 100,000 (or even a million) shares may soon be executed electronically.4
Even so, the average size of block trades is increasing in parallel. Last year, J. P. Morgan executed a $1.9 billion trade; other trades too were reported to involve more than $1 billion. Given this trend, upstairs trading will always be needed. What will change is the definition of a block trade; in other words, the size of trades defined as block trades will increase.
Margins also remain substantial in more complex derivatives and bundled products. There has been tremendous growth, for example, in derivatives that allow would-be IPO millionaires to realize their assets before they exercise their options. Other opportunities exist for structuring intergenerational wealth transfers and for taking short positions on market movements for large investors. In fixed income, demand for credit derivatives is likely to continue growing despite recent hiccups. Bundled products, such as portfolio reallocation, index trading, and arbitrage, are attractive as well.

The low-margin commodity side of market making and brokerage will eventually look quite different from the higher-margin trading side

Over time, the low-margin commodity side of the trading business and the higher-margin areas will look very different. The former will be ruled by programmers developing new trading algorithms; the latter will remain labor-intensive and high touch. For those higher-margin areas, investments in talent will be of critical importance. Still, there will be important synergies between the two sides of the business. Proprietary trading, for instance, will depend on information that is derived from the flow of customer orders. With a strong flow, a trading firm can reduce its inventory and net more trades internally. We therefore expect the leading players to develop strong capabilities in both the automated, volume-driven business and the high-touch areas.

Only a few players will win

With the price of new technologies likely to be several hundred million dollars a year, competing in this new environment will hardly be cheap

With the price of new technologies and talent likely to be several hundred million dollars a year, competing in this new environment certainly will not be cheap. Some players are already investing heavily, and this seems to be paying off: investors report that the biggest spenders on all forms of information technology have lower trading costs than do their more frugal counterparts.
How should banks react? Different, and difficult, choices will have to be made. Institutions with a strong share of trading volume should move full-speed ahead. Given the scale and speed needed to win, Mergers and acquisitions are the most promising way to obtain new technology and order flow quickly; relying on organic growth will be difficult. A global presence is a necessity, since much of the growth will take place outside the United States, and some new technologies—and institutional learning—can be leveraged globally.5
To gain a foothold in other countries, joint ventures may offer an alternative. In Europe, for example, the prevalence of universal banking means that a pure-play acquisition is tough, and an acquisition of a universal bank would bring in several business lines that are much less attractive. At the same time, the biggest players can’t afford to ignore the talent needed for the high-margin parts of the business. Technology, scale, and skills will differentiate the best from the rest.
Yet the game isn’t over for smaller and more regionally oriented institutions. Smaller banks have a good position to make great outsourcing deals with larger players that want to gain order flow. Besides getting paid for order flow, smaller institutions might gain access, for example, to the larger bank’s research and IPO calendar. In Europe, several smaller or more retail-focused players have partnered with large trading houses to offer customers more cheaply executed trades, a broad array of research, and access to European and US securities. In addition, smaller firms can make markets in niche securities for which skill is more important than scale. The regional bank WestLB, for instance, may be able to compete successfully in making markets for some German derivatives.
Trading is being redefined by technology and is creating terrific opportunities for a host of banks. It is clearly time for another look.

About the Authors

Jonathan Davidson is a principal in McKinsey’s Toronto office; Léo Grépin is a consultant in the Montréal office; Charlotte Hogg is a principal in the Washington, DC, office.

McKinsey on Finance on iPad

Using your sales force to jump-start growth

There’s no escaping the impact of the sales force on your company’s growth trajectory. This is the frontline group best placed to gain an intimate understanding of existing customers, to observe the forces at work in an industry, and to identify potential new business. During the past year, we interviewed about 100 sales executives around the world, across a range of industries, to identify the critical elements that distinguish true sales leaders from also-rans. This article highlights four intriguing ideas the executives described for leveraging the sales force to jump-start growth. Together, these suggestions offer practical insights for sales groups, as well as a starting point for discussions among CEOs and other senior managers hoping to get more from sales and marketing investments.

Look over the horizon

The sudden arrival of a truly disruptive technology—one that upends markets in ways few anticipate—presents obvious challenges to industry incumbents. Yet it’s also a huge growth opportunity. One supplier of parts to high-tech manufacturers has created a team of “speculative market analysts” to better identify the emergence of disruptive technologies and to predict their business implications. The team helps the company to position itself as a supplier that’s ahead of the curve and to enjoy superior sales growth while competitors scramble to catch up.
The full-time team cuts across all business units and draws on a variety of internal and external sources: the sales force provides insights into the technology initiatives of the company’s customers while continually pressing them for feedback about its shortcomings and the efforts of competitors. In addition, the team closely scrutinizes all reports from competitors and customers—easier said than done, given the sheer volume of market information emanating from countries such as China. It even fosters close ties with venture capital firms and provides up-and-coming companies with funding and “sweat equity” to convert innovative concepts into realities. Together, these efforts have helped the company’s sales force to get ahead of recent major disruptive trends, including the boom in tablet devices and e-readers, as well as the growing fields of LED lighting and solar technology. What’s more, the team’s efforts are generating an estimated annual return on investment that exceeds 12 percent.

Hunt and farm

It’s easy for organizations to fall into the habit of seeking sales growth only through existing customers. Even though the sales force is typically best placed to find and approach potential clients, individual reps may shun the uncomfortable task of cold-calling in favor of selling to customers they know well. Yet there’s only so much each customer can buy, so finding new business is critical for growth.
One large distributor of auto parts tried tackling this problem by separating these activities. Its sales leader designated some reps as “hunters,” who focused exclusively on finding new prospects, while “farmer” reps concentrated on existing customers. The model succeeded initially but later foundered as hunters became discouraged by the time and effort required for their relatively scant wins, as well as the perception that they were second-class citizens compared with farmers.
As attrition rates among hunter reps grew, the sales leader changed tack. To demonstrate the importance of finding new customers, he designated one day a month as a “hunting day,” when all reps would exclusively chase new prospects. The rest of the time, they could focus largely on existing customers. The result was astounding: in a single day, the company signed up as many new customers as it normally did in two months. Setting aside one day a month for hunting new business is now an ingrained part of the company’s sales practices.

Motivate with more than money

The basic remuneration model for sales reps is simple: a base salary offers security; commissions and bonuses provide incentives to perform. Most companies work endlessly to optimize the balance. Yet what if money isn’t the thing that actually matters most? One financial-services company tried all manner of compensation plans before determining that while carrots and sticks did influence the sales performance of its financial advisers and sales managers, the results were short-lived.
As the company explored alternatives, its sales leader observed something important: the most successful advisers often spoke passionately about the sense of fulfillment that came from helping clients realize their dreams. Fundamentally, that was why these men and women had become financial advisers. The realization that money was just one of the factors driving performance prompted the sales leader to work with managers and individual advisers to develop specific goals that would help the advisers feel they had genuinely helped customers. Maybe it was prioritizing quality over quantity by working more intensely with fewer clients. Perhaps advisers needed a wider range of financial products to ensure that they had all possible options to meet their clients’ investment goals. At the same time, the company identified and laid out steps for overcoming potential bottlenecks, such as a lack of coaching, training, financial-management tools, or appropriate products.
The company knows that money remains critical to its sales team but now recognizes the benefits of identifying other, deeper motivations. The attrition rate among financial advisers has fallen sharply, and they not only have become more successful at winning business but also have found that clients are entrusting more of their wealth with the company. These goals have been met with no increase in the compensation of advisers.

Boost sales without slashing prices

Companies experiencing flat or declining sales often elect to cut prices to spur demand. Yet sometimes, averages lie: a decline across a market doesn’t mean that all market segments are weakening. A North American logistics company learned this lesson the hard way when it empowered sales reps to lower prices to meet management’s goal of boosting volumes. Because the price guidelines were set without taking into account the competitive dynamics of each specific market segment, only some reps recouped the cost of the price cuts with higher volumes. The company’s overall competitive position deteriorated.
Top management decided to recalibrate its approach. The characteristics of each of the company’s various market segments varied wildly. Some were growing fast in the wake of continuing property construction, population influxes, and investment; others were flat-lining. The sales reps got new price and volume targets based on each segment’s characteristics. These targets incorporated metrics such as the economic growth rate in geographies where particular industries were heavy users of the company’s services, the strength of the company’s operational assets relative to those of its competitors, and whether the company was losing or gaining customers at accelerating or decelerating rates.
This granular view of each sales territory led to new sales approaches. In higher-growth markets with limited competition, sales reps aggressively sought new business and raised prices where possible. In declining markets with stiffer competition, reps were authorized to cut prices to prevent customers from defecting. This market-by-market roadmap allowed the company not only to reverse several years of declining market share but also to secure an overall average price increase of 3 percent.

McKinsey on Finance on iPad
https://www.mckinseyquarterly.com/Marketing/Sales_Distribution/Using_your_sales_force_to_jump-start_growth_2781

Leader Fatigue: Making the Difficult Choice to Move On

Late last week when Cathleen Black resigned after just three months as New York City's schools Chancellor, many influential New Yorkers decided that the way to analyze the event was as evidence of their mayor's stumbling. That's quite a turn of interpretation for a man who, for several years, seemed to be able to do no wrong. Not that long ago, Michael Bloomberg was being talked about widely as a post-partisan presidential possibility. The fact that the bloom is now off the rose, and constituents are said to be tiring of him, offers an important lesson in power for all of us.
Let's start by observing the obvious: that anyone who wields great power is bound to rub some people the wrong way, and those disaffected people accumulate over time. They also tend to have longer memories. As Dan Julius, a senior academic administrator now in the University of Alaska system told me years ago, "the things you did that upset people and create enmity live on much longer than what you did that people liked and created supporters." Thus, the goodwill Bloomberg earned during the successful tenure of former schools chancellor Joel Klein, and for the many things he has done to make New York more economically vibrant and livable, is rapidly degrading. People are already forgetting how he took on budget problems inherited from his predecessor, Rudy Giuliani, and helped the city successfully live within its means. Accomplishments seem to have a shorter half-life — at least in people's memories — than animosities.
This is one reason that leaders need to be "repotted" after a long tenure, believed Ernie Arbuckle, the Stanford Business School dean who did much to put the school on its successful trajectory. He noted that it becomes harder to get things done as resentments build and people get tired of you. Arbuckle stayed as dean for 10 years, then left to become chairman of the board of Wells Fargo for ten years, and after that, chairman of Saga Foods, also for ten years. (It will not surprise you to hear that he thought the right moment to "repot" was after ten years.) But he didn't see it as only a problem of perception. He also thought that, after a while in a given position, one's ability to see new challenges and opportunities clearly diminishes.
The problem is that most people, having attained a position of power, are reluctant to leave it and venture into new territory. Often, having racked up accomplishments and seen them celebrated, they are fired up by the possibility that, with a little more time, they could do more. In some cases, they cling to office because their age suggests they will not go on to scale any greater heights. Yale professor Jeffrey Sonnenfeld described this phenomenon in his decades-old book, The Hero's Farewell. In it Sonnenfeld noted that while some aging CEOs exited gracefully while they still enjoyed wide acclaim, many hung on too long, reluctant to face their own mortality. There was William Paley, the titan of CBS, who challenged his biographer by asking just why he had to die. And there was Armand Hammer, CEO of Occidental Petroleum, who put in place a long-term incentive plan for himself with a ten-year payout horizon — when he was in his 90s. Few executives or political leaders are as wise as UCLA's legendary basketball coach, John Wooden, who retired after winning his tenth championship — quitting while he was on top.
My wife has a phrase, "leave before the party's over," which contains much wisdom about the importance of leaving positions before our charms have faded, and about the discipline required to do so. By overstaying, leaders place themselves in situations where they become less effective, tarnish their legacies, and are therefore less able to move on to a new position of power. As Bloomberg's third term wears on, and wears thin, CEOs and other leaders would do well to heed its lessons.