Equity Trading's Future in Europe. (Current Research)

Article excerpt

In Europe, as elsewhere, 2000 was a truly spectacular year for equity trading. In France, Germany, Italy, and the United Kingdom, the industry as a whole made profits of [euro]6.6 billion ($6.02 billion). (1) But 2001 was an equally spectacular bust--industry profits in the four countries fell by more than half (Exhibit 1, on the next page). And the industry's roller-coaster ride isn't over. A new study conducted by McKinsey and J. P. Morgan shows that equity-trading volumes could grow by 8 to 17 percent a year from 2001 to 2005 but that revenues and profits may be more elusive unless wholesale equity brokers adapt their businesses to the changing requirements of their diverse customer segments. (2)

Eckart Windhagen

A rising market and new listings alone will increase overall market turnover by 8 percent annually through 2005. (3) Will it grow faster? That depends on trading velocity: the rate at which investors churn their portfolios. (4)

During the second half of the 1990s, it increased steadily thanks to new trading and order-handling technologies, falling transaction costs, and volatile share prices in a growing market. In 2001, it fortunately stayed flat--if it had dropped as far as market capital did, trading volumes would have fallen much further.

What happens next to trading velocity hangs on changes in demand within market segments and their relative size. Broadly speaking, wholesale brokers serve four customer segments: hedge funds; large active institutional funds and small active institutional funds, both of which pick equities with the aim of outperforming the market average; and passive investment funds (such as index funds), which aim only to mirror the average performance of the equity markets. Although average turnover velocity was approximately 80 percent in 2000 and 2001, the trading velocities of these segments vary a good deal around the mean. A hedge fund, for example, turns over its whole portfolio an average of five times a year, while passive investors typically churn only 15 percent of their holdings annually.

By conservative estimates, overall trading velocity is likely to grow by just 1 percentage point from 2002 to 2005. Although pension funds and insurance companies plan to increase their holdings with high-velocity hedge funds, investment in low-velocity passive funds is also expected to increase substantially, so the velocities of the two will largely cancel each other out. But trading velocity might easily increase faster--more managers of large active funds may make greater use of new systems for handling orders, say. If trading velocity matches its growth rate from 1995 to 2001, total equity market revenues, including those from new capital and new listings, could rise by as much as 17 percent a year until 2005.

In contrast, overall profits are unlikely to rise proportionately. The revenue margins of the trading services offered by brokers differ a good deal (Exhibit 2). While there has been little downward pressure on margins for particular services, investors have shifted a lot of capital to lower-margin ones such as portfolio trades (the simultaneous purchase and sale of a collection of stocks) and bulk trades (which command price discounts) of liquid stocks. This trend, which may well have reduced wholesale-trading margins by as much as 15 percent from 2000 to 2001, is likely to continue as passive or almost-passive investing becomes more popular and trading technology improves (Exhibit 3, on the next page).

How can an individual broker maximize its share of future profits? The outcome depends on how well it adapts its services to the particular needs of each client segment. Most brokers still try to offer the full service: equity research across sectors and countries and the execution of trades in domestic and foreign equities. But not all segments need the whole bundle. …