Inter-dealer brokers (IDBs) are by nature a secretive, competitive bunch. So when it comes to meeting legal deadlines for filing annual results, many firms, most of which are privately owned, wait until the last minute. This past year most have performed so dismally that they had an added reason for stalling. One big broker in London was said to have done so badly that it chose to pay a fine for missing the deadline rather than report on time. The rumour was false, but such is the mood of doom among brokers that it was highly plausible. "There is total disarray in the market," says a London broking firm head. "There is tremendous overcapacity. There will inevitably have to be consolidation."
Not all brokers feel so close to the precipice, but for many the dynamics of the markets they operate in have changed so fundamentally that their survival is in question. Most seriously challenged are brokers in spot foreign exchange. This is primarily because of the rapid growth of electronic broking but also a result of overcapacity among voice brokers (the traditional telephone-dealing services). But nearly every sector of the capital markets in which IDBs operate has been affected. This is partly because of reduced interest rate volatility, but is also the result of a downturn in the growth of derivatives activity last year because of highly publicized disasters, such as the Orange County losses and the collapse of Barings.
"I don't think we are looking at a cyclical change; I think we're looking at a structural change," says David Hagan, head of Trio Holdings in London, which owns the Martin Brokers Group. Because of orchestrated stabilization of interest rates and exchange rates among the G7, Hagan says, "you no longer get the wild swings you used to get". What is more, he says, "our customer base is more focused on risk in the wake of Barings and Daiwa, which has constrained speculative trading. And the consolidation among the very largest banks, such as Chase/Chemical/ManHan and Mitsubishi/Bank of Tokyo, has produced fewer players with a consequent reduction in liquidity."
Translated into the nuts and bolts of broking, this has meant drastically reduced commissions and volume discounts and, at the bottom line, lower profits. Exco's consolidated profits last year were less than half the previous year's, down to £10.2 million ($15.4 million) from £23.5 million. Tullett & Tokyo Forex International reported first-half profits in 1995 (the latest figures available) of £5.8 million, compared with £17.3 million in the same period a year earlier. Intercapital Group reported a drop from £18.5 million in the year ending March 1994 to £7.3 million for the same period in 1995, though it expects improved results this year.
Bypassing brokers
The Bank for International Settlements (BIS) estimates that in April 1995 the average daily turnover in global exchange markets in spot, forward and forex swap contracts was $1,230 billion, compared with $820 billion in April 1992. That, says the BIS, suggests a rate of expansion of 50% between 1992 and 1995, compared with 39% in the previous three-year period. And growth was almost twice as large in forwards - where electronic brokers are not direct competitors to voice brokers - as in spot transactions. In view of this increased activity, why are brokers suffering so much?
In practice, changes in the market are having a differential effect - not all brokers are suffering. The tendency is for brokers with particular expertise and/or dominance of a market sector to get more and more of the business. This was particularly evident in the spot forex market following the launch by Reuters and EBS (Electronic Broking System) of their electronic services more than two years ago; business among the voice brokers migrated to the big players, MW Marshall in particular, but also Tullett & Tokyo and Harlow Butler. This forced other firms, such as Trio and most of Exco's spot forex operations, out of the market altogether. Although the electronic inter-dealer broking offered by Reuters and EBS (the short-lived Tokyo-based Minex system has been absorbed by EBS) operates only in the spot forex market, other electronic systems and screen-based pricing, sometimes offered by the brokers themselves, have made it easier for financial institutions outside the dealer loop to deal directly with banks - or among themselves - bypassing brokers altogether.
Reuters' Dealing 2000-1 (which preceded the Reuters electronic IDB, Dealing 2000-2) enables financial institutions in virtually any financial market to execute and settle deals automatically without going through a broker (and brokers themselves are big users of the system). Meanwhile, firms such as Intercapital offer screen-based prices for interest rate swaps and options. Intercapital's Reuters page has become one of the most closely watched in the world. These electronic systems probably go some way toward explaining why the category of "other financial institutions" (those outside the dealer loop, such as institutional investors) are playing a bigger role in forex trading. The BIS survey showed that while inter-dealer activity still accounted for two-thirds of overall foreign exchange turnover, "other financial institutions" increased their market share from 12% to 20% between 1992 and 1995 at the expense of non-financial institutions and bank dealers.
The success of Dealing 2000-2 and EBS (owned by a consortium of banks) in spot forex is indisputable. As part of its April 1995 survey for the BIS, the Bank of England (BoE) reported that brokers still handled 35% of the total foreign exchange business in London (which accounts for almost twice as much turnover as the US and handles 30% of worldwide business). Of the 35%, 30% was handled by voice brokers and 5% was electronic business. (Electronic brokers did not figure in the 1992 survey.) In the US, electronic brokers handled 13% of the business, with voice brokers' share of the market falling from 30% in 1992 to 24% in 1995. The BoE survey pointed out, however, that the electronic brokers' business was mainly in three currency pairs: 77% of the deals they handled involved US dollar/Deutschmark, Deutschmark/French franc and Deutschmark/Swiss franc.
Since 1992, voice brokers have been hardest hit in dollar/Deutschmark trading, with their share of London interbank spot business falling from 39% to 26%. There was one bright spot: as electronic broking has taken off it seems to have encouraged more trading. "Over the same period," says the BoE report, "the electronic brokers took 23% of the London market in the currency pair, indicating that nearly half of this turnover came from the creation of new brokered business - typically low-value interbank transactions."
A year later, Reuters estimates that in the spot market overall the two electronic systems now control 40% of the business by volume. Roslyn Wilton, Reuters' managing director for transaction products, says that with some 4,500 key stations in over 1,000 banks, Reuters now brokers 25 currency pairs, with 90% of the business coming from eight of these. EBS is concentrated in fewer currency pairs and in the lucrative dollar/Deutschmark market is very strong . "It's really taken off much quicker than we anticipated," says Wilton. "The first year was tough, but once we reached a critical mass it just took off."
Voice brokers such as Trio were badly hit by the rapid expansion of electronic business. "In the beginning of '94 EBS would do $10 billion a week in dollar/Deutschmark business," says Trio's Hagan. "By the end of '94 it was up to $20 billion a week, whereas we we would average $30 billion a week on our spot desk in Germany alone. But from the beginning of '95 EBS went up an exponential curve and it is now in excess of $100 billion a week." Even successful firms like Marshall found the going tough. "We haven't lost market share among the group [of voice brokers], but the group itself has lost market share," says a Marshall source. "With the electronic systems and pressure on commissions you're having to run to stand still."
Trio took the strategic decision to leave the spot forex market late in 1994, closing the London desk early in 1995, pulling out of spot in Tokyo and Hong Kong in the middle of the year, then closing Singapore. In October it sold its German business, Bierbaum & Co, to Exco. Recently it has announced the sale of its Swiss office to a domestic Swiss broking company. Overall, in the past 15 months it has reduced its staff from some 900 to 450. "We had seven desks in spot dollar/Deutschmark," says Hagan. "We now have none. We don't do spot forex at all, which for many years was a core product for Martins. Our core products now are forward foreign exchange, arbitrage, deposit broking, domestic sterling and, globally, some highly specialized niche areas such as OTC equity options."
Exco also reacted dramatically, slashing its workforce last year by 17% and closing almost all its London spot forex operations. "There is evidence that the advent of the electronic matching systems has changed the nature of the spot foreign exchange market," says Exco chief executive Peter Edge in the company's latest annual report. "This caused us to re-evaluate our position in this market and we decided to focus on the major international products and on our existing strengths, withdrawing from products where we judge the prospects to be poor." Although Exco's £6 million purchase of Bierbaum in October 1995 included that firm's flagship Düsseldorf-based spot dollar/Deutschmark business and its Frankfurt deposit-broking business, the move has been portrayed in hindsight as being motivated more by a desire to get hold of the Frankfurt fixed-income securities business and to gain a stronger continental footing.
"The electronic broking system has basically changed the whole market," says Thomas Fischer Henrichsen of Exco Bierbaum in Düsseldorf. "We've been hit on two fronts. The turnover has fallen and the commission has fallen." In the "old days", he says, there were five-pip spreads, whereas now they are one or two; and whereas a couple of years ago the commission would be Dm25 per $1 million turnover, the rate is now half that. As in London and other major markets, smaller banks that once depended on voice brokers to execute trades now find it cheaper to use electronic trading, bypassing not only the brokers but also the big banks. The ability of these smaller players to deal direct is certainly a significant element in falling spreads and commissions; big banks and brokers no longer hold all the cards.
One potentially hopeful event for Exco Bierbaum is the decision of media/broking conglomerate MAI to move its business in dollar/Deutschmark from Frankfurt to London, with effect from July. Its German-based Müller team will work alongside MAI's London-based Harlow Butler broking team, creating a larger operation in one centre and enabling the company to economize on its communications network. This may leave the field more open for Exco Bierbaum in Germany. "It gives us a much better chance on the Continent," says Henrichsen.
Although spot forex is proving difficult for traditional players, other foreign exchange markets, particularly options, offer some hope. The BIS survey reported gross turnover in swap markets rising by 56% in the three years to April 1995 and turnover in options more than doubled (although options still accounted for only 4% of overall activity). Swaps now account for the second largest volume of turnover after spot transactions, whose share fell from 58% to just under half, the BIS report said. In London the proportion of gross turnover accounted for by forwards increased from 48% to 59%, with nearly 80% of the increase coming from activity in the swaps market.
This increase in forward activity has been a big boon for some brokers. Cantor-Fitzgerald, a New York-based broker which made its name in government securities, is a case in point. It does not broker spot deals, but within the past few years it has moved aggressively into forwards, focusing initially on the two most actively traded currency pairs, the dollar/Deutschmark and dollar/yen. With its well-established worldwide network of screens it had a natural position for advertising prices and gave its customers a new way of doing business on the market. It claims to be the only brokerage firm to offer screen-based brokerage of forex forwards, and plans to provide a non-name give-up service (the usual practice is for clients' identities to be revealed for purposes of clearing and settlement after the deal is struck); its strong $200 million capital base allows it to provide in-house clearing for clients. "If you call other brokers about forex they groan," says Howard Lutnick, president and CEO. "Our revenues in forex were up 150%-200% at the end of last year." And although forex is still a small part of the business (US government securities and equities account for almost half), Lutnick says, "Foreign exchange is the fastest-growing business we have."
Trio is developing a software system to enhance its broking operation. It will be similar to the equity IDB screens in London, which Hagan had a large hand in developing while at Tullett & Tokyo. He believes that Trio controls a significant share of the London forward market, particularly in longer-dated instruments (over one month) - and that if the electronic firms move into the market he could benefit in the same way as large players in spot forex have. "If we're at or near the top of the pack the migration of liquidity will come to us," he says.
The old world of voice broking is rapidly being transformed rather than disappearing. Even in spot forex, where electronic brokers offer direct competition, it is doubtful that voice brokers will entirely disappear. For one thing, the electronic brokers don't want them to. Voice brokers add flexibility, thus contributing to liquidity. And although the banks themselves participate in EBS, it is not in the interest of their dealers to have the market dominated by one system.
Niche markets
One tendency is for smaller trades to be routed through the electronic systems and bigger tickets to be handed to the voice brokers. Reuters' Wilton suggests that this may be gradually changing. She now sees the occasional $10 million, or even $20 million, deal appearing among the average $1 million to $2 million lots on the electronic system. Nevertheless, it would seem that dealers for the most part still prefer the familiarity of a trusted voice broker who can use his discretion in finding takers on the other side. "I would suggest a verbal broker in forex has an average trade seven to 10 times larger than an electronic one," says Cantor-Fitzgerald's Lutnick.
What's more, voice brokers can still make money in the less mature spot markets. Prebon Yamane, which decided five years ago to stay out of the high-volume markets (dollar/Deutschmark, dollar/yen, etc), has remained in less mature sections, such as spot Ecu and emerging Asian markets. As a result, says Prebon Yamane deputy managing director Stephen Miles, electronic trading "has not had anywhere near the effect that it is has had on some of our competitors".
Electronic brokers look set to move into the forward markets - as early as the end of this year some brokers believe. The electronic firms are reticent about their plans, but admit to looking actively at the possibility. Computerizing bank credit positions over time is problematic. In the spot market, the credit position is easier to handle: the computers hold the limit of every bank with every other bank - and that can be adjusted daily - so the price displayed to the user is absolutely firm. In forward markets, however, credit limits vary. A bank with a £500 million limit for overnight transactions may have only a £5 million credit for a five-year deal. Some brokers believe the sheer number of limits a computer would have to hold would make it impossible for electronic brokers to go beyond one month. Reuters' Wilton acknowledges the problem: "The credit side of forwards is much more complex than in spot forex. It's going to be some time before we feel comfortable we have something that works."
Even in sectors without electronic competition, the broking business is proving as tough as it is in spot markets. The various fiascos in derivatives have taken their toll. "There was this obsession with risk, how to minimize it, exacerbated by Barings and Daiwa Bank, and it had a huge dampening effect on speculation in the money markets," says a broker. The total notional amount of all privately negotiated new contracts among the member firms of Isda (International Swap & Derivatives Association) in interest-rate swaps, currency swaps and interest-rate options rose nearly 45% in the first half of 1994, but in the second half fell from $4.2 trillion to $3.9 trillion (within the three categories, only currency swaps rose). Activity picked up again in the first half of 1995, but not to much above the level of the first half of 1994 (final figures for the year are not yet available).
Swaps are the second most actively traded product in the forex markets, but brokers are finding it hard to make money on them because they have become relatively standardized, which means they can often be negotiated without brokers. When they do go through brokers, standardization means that banks have more leverage to squeeze commissions. Options are the "new game in town", says one broker. But they do not yet offer the volume that big brokerage firms depend on.
Success in niche markets breeds competition from large brokers seeking volume. Intercapital chairman Michael Spencer started broking interest rate swaps in 1985 and had a successful run for many years. Ten years later, though, Intercapital had to fight hard to maintain its share of a market it largely created (the firm's misfortunes were exacerbated by the loss of its entire emerging markets team to Cantor-Fitzgerald 18 months ago - a new team is expected to be in place within a few months). Over the past five years commissions on interest rate swaps have dropped by 70%, Intercapital managing director David Gelber says. Commissions are now of the order of a quarter of a basis point and other brokers complain of even higher volume discount arrangements. Gelber says there is no choice. "Sensible brokers will enter into volume discount arrangements. You cannot be a niche player in this environment," he says.
The firm is starting to recover. Gelber says profits showed "considerable" improvement in the year ending in March. "Commissions haven't risen in the last 12 months but we have increased market share," he says. The firm is beginning to see light at the end of the tunnel - at the expense of the competition. "I now think commissions have reached a point where some firms are going to find it hard to survive. The name of the game is market share," he says.
A more recent London success story is a firm called Sunrise. Five years ago Mike Hudson, its founder, saw an opportunity in equity index options. "When we set up, there wasn't a market," he says. "Since then our revenue has doubled every year. I see revenues going up and up and up. The only thing that will stop it is some sort of regulatory change." But Hudson is aware that Sunshine will have to adapt, since firms like Prebon Yamane and Trio are moving into the area. "It's a bit like a product life cycle curve. As a market gets more deep and liquid you get more conservative institutions coming in." And, by definition, more brokers. So Sunrise has moved into over-the-counter options markets in aluminium, gold and other metals. "We want a market with the same kind of margins and volume - relatively underdeveloped," Hudson says.
But for most firms, the outlook is pretty dismal. Their trials have been reflected in their stock market performance. Trio's share price was 50p early in 1994 but hit a low of 6p and is now only 7.5p. Exco's was 200p in September 1994 and is now only 102p. Other firms, such as Intercontinental Exchange Partners and Cedar Street in Switzerland, have gone out of business altogether. Not surprisingly merger rumours are flying: will it be Prebon and Marshall, or Exco and Marshall - or Marshall and Trio? Will MAI demerge Harlow Butler and Garban as it concentrates on its flashy new media business? What about Tullett? The problem for most of these firms is that even though they can be major cash cows, they are difficult to value because their biggest asset is goodwill. A number of them, still burdened with debt from the last round of mergers and takeovers, now technically have negative net worth. One thing is certain. Brokers are keeping a close eye on each other's balance sheets - that is, once the companies have got around to filing them.
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