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Inside Wall Street Two Arrows

by WealthEffect Staff

The research and sales operations at the brokerage firms are responsible for creating and disseminating investment advice. In return for this advice, retail and institutional clients buy and sell stocks through the trading operations of these firms, generating commissions for the brokers.

For half a century, Wall Street was content, even insistent, about limiting its exposure to losses. It focused its operations on agency business, executing orders for others and taking a commission. In recent times, however, the trend has been toward principal trading, in which firms risk their own capital rather than simply put together buyer and seller.

The catalyst for this change in the trading equation was the growth of institutions as the major factor in the stock market. The abolition of fixed commissions on May 1, 1975, allowed large institutions to use their influence to negotiate sharply reduced commission rates. (How many other goods or services can you think of that currently cost a small fraction of their price a quarter century ago?)

The reduction in rates has hurt the brokers significantly. This is a high fixed-cost business — the rent, heat, phone, and light bills have to be paid, regardless of sales. Offsetting the pain of reduced commissions per share has been the massive increase in the number of shares traded each day. Trading volume on the New York Stock Exchange now averages several hundred million shares each day, up from 14 million in 1974.

As institutions became a larger and more powerful force in the stock market, they have also encouraged the growth of principal transactions, in which the brokers themselves act as buyer or seller of last resort. This occurs when the market won't accommodate large trades.

For example, if an institution wants to sell 600,000 shares of IBM, and there are only buyers for 400,000 shares, the brokerage house might buy the other 200,000 for its own account. Now the broker is at risk: if the price falls ¼ before the shares are resold, the broker loses $50,000 on its 200,000 shares. This loss more than offsets the commission (on the full 600,000 shares) which might average $.06/share, or $36,000.

The majority of principal transactions lose money. In this example, once the 400,000 shares have been sold, there are few if any natural buyers left for the remaining 200,000. Supply will initially exceed demand, which is not encouraging for the one with the excess supply.

The bottom line is that the brokerage industry no longer enjoys the immense profits at low risk that once it did, as institutions demand lower commission rates and higher capital commitments. Meanwhile, individuals are offered lower rates to slow their exodus to discount and on-line brokers.

Well, you might ask, if it's such poor business, then why do it? The answer is that success in the brokerage business is closely related to distribution. The brokers want to be on good terms with their customers, particularly the large institutions, in order to get the opportunity to underwrite lucrative new issues (IPOs). A primary attraction of one broker over another to a company issuing stocks or bonds is the broker's ability to distribute the securities broadly, and at a favorable price (for the company, that is).


Suggestion: Go to Investment Banking