Brokers play an extremely important role as intermediaries in market transactions for institutional investors. Electronic trading has become a dominant force in the market, but many firms still prefer to talk to a salesperson or trader by phone. There are several reasons for this preference, but perhaps most important is that voice communications facilitate relationships between clients and traders and help build trust. Investment managers rely on a network of such relationships, and every firm must work with a variety of brokers to achieve optimal results.
To protect investors, various regulators mandate that investment managers must seek the most advantageous terms for their clients when executing trades. In seeking best execution, investment managers should consider the full range of services a broker offers, including execution capability, research, commissions, responsiveness, and financial responsibility. Each client’s individual needs, coupled with the security being traded, will determine which of these factors takes precedence. To achieve the best execution for every client, an investment manager needs relationships with a range of brokers, each of which will have its particular strengths.
Don’t put all the transaction eggs in one broker basket
Diversification is a foundational principle of finance and it applies to more than investment portfolios. Take clearing brokers, for instance. Acting as a liaison between the investor and the clearing corporation, the clearing broker ensures that the trade settles and the transaction is successful. To manage and diversify risk, firms should avoid concentrating all their assets with one broker. With a diversified pool of brokers, the risk to assets is contained.
Credit risk is always a concern and it goes both ways.
Both sell-side and buy-side firms have a range of requirements in terms of evaluating credit risk. From the buy-side perspective, access to a range of brokers will ensure that the firm not only has the opportunity to seek best execution but will also have alternatives when their creditworthiness is being evaluated. On the sell-side, client selection is becoming increasingly stringent, and in many cases, risk committees only approve the most traditional counterparties that trade the most liquid products and boast significant assets under management.
Brokers have different areas of expertise
Some brokers are strong across the board, while others offer expertise in a specific area, perhaps in a geographic region like Africa or in the oil & gas sector. Efficient execution is an obvious reason for choosing a broker, but specialization and other factors are important as well. One broker may offer exceptional research, while another is a rich source of order flow information. The nature of the individual trade, as well as a client firm’s research expertise, can often determine the choice of broker used to execute the trade.
Clients have increasing power over transactions
In today’s market environment, clients have more power than they once did. It used to be that brokers dictated price and the client said yes or not. Now, clients have more scope to say what they are willing to pay and can use multiple brokers and split clearing to obtain the pricing they desire.
Firms are looking for a broader range of algorithmic products
Algorithmic products offer significant value to investment managers, as they can lower commissions, reduce the market impact of trades, and protect anonymity. By using a range of brokers, clients can gain access to an expanded universe of algorithmic products that may be developed by the broker or a third-party. A greater range of products to choose from allows the investment manager to find the best alternative to achieve each specific objective.
A changing regulatory landscape also suggests the need for multiple brokers
MiFID II, the European legislation rolled out in 2018 to restore confidence in the financial markets, has had a significant impact not only in Europe but on US firms as well. MiFID II seeks to hold investment managers accountable to best execution standards and offer greater transparency in broker services. For example, bundled services and soft dollar arrangements are more heavily scrutinized and European clients are required to keep clearing within Europe. Given the greater complexity of regulation, firms must ensure that their range of broker relationships will facilitate best execution for every client.
A plethora of reasons suggests that firms maintain relationships with multiple brokers to ensure best execution for every client. Investment managers can be pro-active and develop relationships with a range of brokers or face a situation in which the investor insists on using their own choice of broker. Firms that have developed multiple relationships can ensure client satisfaction while still using vendors of their choosing.
About the Author
Rebecca Baldridge, CFA, is an investment professional and financial writer with more than 20 years of experience in creating content and research for asset managers, investment banks, brokers and other financial services clients. She’s worked for some of the biggest names in the industry, including Merrill Lynch Asset Management, JP Morgan Asset Management, BNY Mellon and Franklin Templeton. Rebecca also spent 9 years as an analyst and director of equity research in Moscow, working for several Russian banks. In late 2019, she founded Quartet Communications, a boutique communications firm serving financial services clients. Her writing has been published in outlets including Pensions & Investments, MSNBC.com, Inc. magazine, and Investopedia.com. She holds a B.A. in Russian from Purdue University and an M.S. in Finance from the Krannert Graduate School of Management at Purdue.