As the story goes, one day the legendary J. P. Morgan was walking along the beach with a client. Morgan pointed to all of the beautiful yachts at anchor in the harbor naming their prestigious owners. Reputedly, the client said: “Where are all the customers’ yachts?” Ironically, today one might switch the tale and ask where are all the brokers’ yachts?
Most observers know that this has been one of the longest, if not the longest, “Bull market” in history. Since the end of 2009 to the present, the S&P 500 has climbed 12.1 percent per year and nominal GDP is up by an estimated 3.9 percent annually. Yet, working with S&P Global and reviewing the documents that the top six banker/brokers file with the Federal Reserve, it appears that the revenues derived from investment banking, trading, brokerage commissions, and fiduciary fees have only grown by 1.2 percent per year since 2009.
Have the customers actually made more money than the brokers in this past almost decade? It appears so.
Surprisingly the falling domino story here starts with technology. I have been told that there are computers today that can process 150 billion floating point flops in a second. I have no idea what that means other than that computers are very fast. Very bright programmers have utilized the new tools made available by the new technologies to create three compelling new products lines:
Exchange traded funds (ETFs)
High frequency trading (HFT)
Large data delivery systems
These products have changed the structure of the capital markets business in the United States in multiple fashions. For example, ETFs are restructuring the nature of the asset management business. ETFs give investors more latitude in investing, and greater control over their money. Plus, they do this at lower costs. High frequency trading lowers the cost of investing even further. Plus, it allows investors greater flexibility in trading. Further, the new large data delivery systems eliminate the need for much labor intensive research.
The success of the new products has upended numerous parts of the traditional capital markets business. For example, the new ETFs have grown from 645 in 2010 to 1,289 at the end of 2017. The Investment Company Institute (ICI) indicates that at least $3.4 trillion in funds have moved from active managers to passive managers like ETFs. The active managers are seeing their profits drop and, to further exacerbate their problem, they are being forced to cut their prices. The ICI indicates that 25 Fund groups left the business in 2016 and 2017.
The remaining managers then demand lower prices from their suppliers – the broker/dealers (B/Ds). The B/Ds not only have to contend with this pressure but the high frequency traders are driving commission prices to below $0.005 per share. The financial Institution Regulatory Authority (FINRA) has indicated that on a net basis 1 of every four B/Ds has left the business since 2009. That would be 1,165 FINRA members. An incredible net 19,259 branches have been closed and a net 34,843 FINRA registered reps are gone.
There are no numbers that I can find that indicate how many analysts are no longer in the business. However, consider that neither ETFs nor HFTs have any use for these researchers. Plus, the big data firms can deliver more information, more efficiently, and in better format than any analyst and his or her associates.
The ICI tells us that five fund sponsors now manage 50 percent of all of the invested funds in the country up from 36 percent a few years ago. This is an estimated $11 trillion, plus. As noted 25 percent of the registered B/Ds are gone leaving the biggest firms to dominate the industry. What this means is concentration, concentration, concentration on the biggest investments available.
It means that the remaining funds must put their money into the biggest firms. It means that the biggest deals will get done because they are cost efficient for the B/Ds. It means that smaller entities seeking money must go to the private markets giving up a great deal of control. It means that SEC FD or not, research will be driven by corporate finance – no other entity can afford it.
It means that the name of the game is momentum. As long as psychology remains positive all of the new mechanisms will flow funds into investments. Woe be the day when confidence swings negative, however, because the incredibly rapid flow of funds out of the markets facilitated by new algorithmic trading techniques is going to be wondrous to perceive.
The Fourth Industrial Revolution is here. The financial industry is one of the sectors most impacted.
The brokers will have no yachts.
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