How Small Broker-Dealers Can Survive in Today's Shifting Trading Landscape

NEW YORK (TheStreet) -- If you're a small to mid-sized broker-dealer, you know your industry has seen significant consolidation in recent years. Let's look at how you can survive in this environment.

Since the financial crisis, the U.S. broker-dealer sector has been a hotbed for mergers and acquisitions. A noticeable uptick in consolidation occurred between 2008 and 2010, coinciding (understandably) with the introduction of Dodd-Frank reforms.

The number of broker-dealer firms registered with the Financial Industry Regulatory Authority dropped to 4,040 by April 2015 from 4,578 in 2010, a nearly 12% decrease over five years. Most analysts and industry experts agree that there are two primary factors fueling this trend: shrinking margins and swelling compliance costs.

Small, mid-sized and specialty broker-dealers are at the center of this consolidation. Many of them lack the cash flow and technology to overcome today's strict regulatory environment. Despite these dreary numbers, hope is not lost. Independent broker-dealers that have yet to merge or become acquisition targets still have options available to capitalize on their evolving industry.

Squeezing the Middle

Similar to the airline industry's restructuring during the '80s and '90s, a handful of large players are eagerly snapping up regional and middle-market broker-dealers. Businesses including Cetera Financial, RCS Capital (RCAP) and AIG's (AIG) AIG Advisor Group have grown their portfolios by purchasing firms that likely didn't have the resources or client base to stay out of the red for years to come.

During and after the recent economic recovery, smaller brokers that did little to differentiate their service offerings (in terms of research, trade execution or asset coverage) or improve their operating cost structures began experiencing a downturn in activity. Business that didn't shift to the bigger firms went instead to boutique shops that support a niche set of securities or focus heavily on research. 

For better or for worse, this recent wave of consolidation has been a necessary chapter for the broker-dealer sector. The large serial acquirers have the budgets, staff and margins to compensate for the gaps that plague small and mid-sized firms. In volatile times (when losing a client or two could bring a broker-dealer down), mergers and acquisitions are enticing alternatives.

Turning the Ship Around

Despite the challenges facing middle-market broker-dealers, it's not too late for them to revitalize their operations (even without consolidation). Firm leaders can take it upon themselves to develop closer relationships with research houses in order to flesh out their own capabilities. Better yet, broker-dealers can finally invest in technology to address their most severe pain points.

Over the last few years, innovations in post-trade software have caught up to the needs of today's high-frequency capital markets, even if most broker-dealers have not. By pairing the right back-office tools with updated internal processes, firms can more closely track trade-execution costs and verify exchange invoice accuracy, providing critical visibility into their true margins and profitability. The less time employees spend managing executions and billing by hand, the more resources they can devote to revenue-enhancing work, such as adjusting trade strategies in response to real-time market trends. Even commission-sharing agreements and other soft dollar programs can get a welcome boost from automation. Applying technology to these services ensures that commissions are credited correctly, and gives clients a clearer view into their accounts.

Another option, even for middle-market broker-dealers, is to line up acquisitions of their own. If there's a particular customer base a firm wants to reach, it might make sense to takeover another broker-dealer that focuses on that security. If a firm wants to build out its support for existing clients, it may look to lure talent from other broker-dealers in the midst of their own restructuring.

The capital markets industry is full of uncertainty, but one likely constant is the pace of broker-dealer consolidation. Firms will continue to be bought up, combined and folded for years to come. Armed with this understanding, smaller broker-dealers should take a deliberate approach to charting their futures and identifying a strategy that will work for their businesses, staff and customers in the long term.

 

This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.

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