End of the road for the traditional stock broker?

Depending on the source you use there are varying estimates of the numbers of standalone brokers and sub-brokers who have gone out of business in the recent times. A lot of reasons have been attributed for this, the financial environment, increased regulation and costs of compliance, technology, internet and the rise of discount brokers, lack of retail participation etc.

So is this the end of the road? I believe not. This is not unique to India. It is just the way the market evolves as it matures. This has happened in the US and other developed countries and India is only now playing catchup as it reaches a similar stage of growth and maturity. So players may be able to create a defensible competitive position by looking at how the industry shaped up in (say the) US post a similar structural change.

With increased internet penetration, access to information, and better technology, the role of the traditional broker (as members and owners of the stock exchange, providing access to the market) has undergone a change. Here are some interesting pieces from an ICRA report

  • penetration of Direct Market Access (DMAs) has stabilized at ~30–35% of overall volumes
  • the domestic institutional brokers’ share has slipped to ~25% while that of the foreign brokers has strengthened to ~75% compared to the usual one-thirds and two-thirds share respectively in the past
  • online trading, accounts for ~35–40% of retail volumes

As FII inflows and interest increases, they bring with them international brokerages; who they are comfortable working with. These large brokerages are in some sense now competing with the exchanges via their own dark pools. Flash boys by Michael Lewis gives an interesting account of the rise of High Frequency Trading (HFT) and dark pools. In order to maintain their share as market makers, the exchanges themselves started providing direct market access to large institutional players. This explains the figures mentioned above.

With internet penetration and increased education of the retail customer, came the discount brokers who essentially targeted the do it yourself (DIY) segment with rock bottom brokerage fees. E Trade is an example from the US. We have our own too. Zerodha and RKSV to name a few.

This has put the traditional full service brokerage model at risk. The institutional business is at risk from DMA and foreign brokers, not to mention the increased inflows into passive funds which do not churn their portfolio as much. The retail business is at risk from the discount brokers.

So how did this play out in the US?

The players were forced to re-think and determine the market they wanted to compete in, as their ability to extract economic rents by virtue of providing market access collapsed once exchanges were demutualized.

When your business model is disrupted by technology that enables the same set of activities to be done cheaper and faster, unless you have a unique value chainthat is difficult to replicate or a proprietary technology platform, competing on cost and staying profitable are a challenge. The natural step then was to identify your unique selling point (USP).

Each firm based on their capabilities, competencies and availability of capital focused on a section of the value chain. Those that continued in the traditional brokerage business either diversified into other services, or specialized in a geographic area (for e.g. William Blair) or an industry sector (Cowen). Others decided to specialize in research (Bernstein) or execution of trades (high frequency or otherwise). Some others focused on other ancillary services like clearing and settlements services or providing technology platforms to smaller players.

On the retail side, the services provided shifted from a stock picking and providing ‘tips’ to providing personal finance advisory, portfolio management services, wealth management, and agency or distributorship for others providers of financial products like insurance or mutual funds. In effect de-risking the business model, focusing on customer relationship and customer acquisition for providers of financial products.

This gave rise to independent financial advisers and financial planners. In India too, SEBI has come up with guidelines for investment advisers. While this has its own set of regulatory and ethical issues due to conflict of interest because the revenue generation is from commissions, but that’s a separate issue. This is a very attractive proposition for the small businesses who do not have the scale or the wherewithal to invest in technology and platforms.

And some others found a very unique play. See liquidnet. It allows for institutional players to trade on larger volumes without effecting market price amongst other things.

We are seeing a similar trend in India. The bigger well capitalized players are investing in technology infrastructure. The days of the jobber executing your trades via orders placed on the phone are limited. Most of them are diversifying into allied services or distributorship to diversify the revenue base. Some others are emphasizing their research. See below the list of services the bigger players are now providing

Motilal Oswal : Broking and distribution, institutional equity, investment banking, asset management, private equity, wealth management, housing finance.

India Infoline (IIFL): Financing, institutional equities, private wealth management, insurance brokerage, housing finance, gold loans, Nifty ETF, Real estate fund, alternate investment fund, advisory for succession and estate planning

Edelweiss: Asset Management, Capital markets, life insurance, credit / financing

These players have a conscious strategy of diversification. For e.g. Edelweiss talks about synergistic diversification and building a bank like diversified business, IIFL states its vison to be a the most respected financial services company. I agree that these were never a brokerage only company in the traditional sense, but they do have or had a noteworthy brokerage business. With the RBI allowing for new banking licenses, should some of them in the future apply for and get a banking license, they would be competing with the larger players (for their core business) and will also face some competition from online players on their agency / distributor business, particular with e-commerce players buying stakes in financial product aggregators. Amazon recently invested in BankBazaar.

I already mentioned about the Indian discount brokers like Zerodha, RKSV,TradeSmart Online, etc.

So the other small and medium or tier two players, risk being caught in the middle. They (like what we saw in the US) would have to either make a play for the big stakes via investment in technology and diversifying into allied services and compete with the leaders head on or would have to think deep and identify their core competency and specialize.

I am yet to see or hear of any notable moves in this direction.

Are you aware of any interesting strategies pursued by smaller firms in this space? It would be interesting to see how similar or dissimilar the evolution is compared to what we saw in the developed countries

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