These 5 Mistakes Can Cost Broker-Dealers Money and Business

NEW YORK (TheStreet) -- Broker-dealers are making a big mistake by not paying greater attention to how they manage the fees their clients for executing trades in stocks and other financial products.

Over the past 15 years, there has been a systemic shift in the capital markets. A sector that was once dominated by a handful of exchanges and flat execution rates now sees a new exchange emerge every few months, along with complex fees that change even more frequently.

Unfortunately, many broker-dealers have failed to evolve accordingly. Many spend time and resources analyzing "best execution," low-latency solutions and new algorithms. But brokerage, clearing and exchange costs (known in the industry as "BCE") are their third-largest expenses, behind people and technology.

Broker-dealers may treat execution fees as a minor concern, but the accumulated costs of client trades are significant and can be the difference between offering quality service and falling behind. In an industry struggling with tight margins and consolidation, firms that lack the resources to stay on top of fluctuating execution costs are the most vulnerable.

For broker-dealers that face some or all of the following challenges, it's time to rethink the fee management status quo.

  • Absorbed execution-fee costs: Few broker-dealers comprehensively track execution fees on a per-client basis, often leading firms to absorb some portion of the fees. Many broker-dealers still charge clients flat rates, but these are crude estimates at best. Without visibility into the extensive attributes that factor in to any equity or options trade (e.g., penny pilots, linkage fees), firms' approximations can fall short of their actual expense. In the long term, broker-dealers that operate with this blind spot may never know what margins need to be sustained in order to remain profitable.
  • Inaccurate execution-fee invoices: Contrary to popular opinion, exchange invoices are far from infallible. Invoices can be off by as much as 20% to 50%, and a casual glance isn't enough to detect errors. When broker-dealers attempt to manage execution fees by hand, these efforts result in a jumble of spreadsheets that compound the risk of human error. Without dedicated audit teams or sophisticated software, broker-dealers can't verify the accuracy of their execution-fee invoices or charge clients appropriately.
  • Inability to measure client profitability: Broker-dealers must be able to determine how execution fees affect profitability at the individual client level to both maintain strong customer relationships and stay competitive. Though most exchanges have transitioned away from flat charges toward multivariate execution fees, many broker-dealer contracts still lag behind. As a result, the fees charged to clients are divorced from actual trade costs, threatening revenue and client trust. More problematically, firms that can't present clients with detailed invoice breakdowns upon request risk appearing incompetent or manipulative.

  • Fee-schedule uncertainty: Unlike large investment banks and other financial institutions, it's rare for broker-dealers to employ dedicated execution-fee analysts. This resource gap leaves many firms in the dark when exchanges tweak their fee calculations and schedules. Considering that there were more than 60 U.S. equity exchange fee adjustments between 2007 and 2010 alone, small and midsize firms could lose hours trying to update their internal records and determine the impact on their profitability. For broker-dealers that bravely attempt manual fee-schedule tracking, it's unlikely that they're accounting for specific details such as volume discounts, trade attributes and other critical information.
  • Inefficient order routing: Broker-dealers that fail to efficiently manage execution fees regularly inhibit strategic decision-making. As fee schedules and client order volumes change, it's the firms with sharp analytics capabilities that can switch gears midmonth to take advantage of volume trade discounts and other cost-saving measures. Even if one client's monthly trades are far below the level needed to qualify for discounts, broker-dealers with accurate data can bundle multiple client orders to obtain the best rates, passing savings back to clients or to themselves.

Adept execution-fee management is intrinsically linked to broker-dealer success. Firms with the tools to analyze fees in real time are most likely to thrive, while those wrestling with outdated processes will continue to endure profit leakage and diminished client loyalty.

For broker-dealers that struggle to navigate execution fees but lack the resources to employ large fee-analysis teams, better technology may hold the answer. Advances in back-office platforms have kept pace with the changing nature of the capital markets; firms no longer have to settle for imperfect manual fee assessments or tedious spreadsheet calculations.

The right solution will automate these operations, reducing the risk of human error and the time required to effectively manage fees. Contrary to popular belief, back-office tools serve to support -- not replace -- broker-dealer staff. Freed from mindless number crunching, employees can apply their talents to more strategic, profitable initiatives.

In the fast-paced realm of capital markets, it's easy to lose sight of less glamorous functions such as fee management. Broker-dealers that want to protect their revenue and future have to break this habit first.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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