(WS 2007/08) Übungen Brokerage andSstandards in Securities Trading PDF

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(WS 2007/08)...

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Brokerage and Standards in Securities Trading - Exercise 5 Bartholomäus Ende Chair of Business Administration, especially e-Finance

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What are soft commissions at all?

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“Soft commissions represent payments made directly from client funds to brokers for research and other services which are effectively “embedded” in the commission fees which the fund pays for each trade. Generally, funds which pay soft commissions commit in advance to paying a minimum annual level of commissions to the broker in return for these services” (Domowitz&Steil, 1997)

“To see how soft dollars work, let me tell you about my recent experiences looking for office space in Manhattan. A good setup for four to five people can cost as much as $10,000 per month, which is a significant cost for a small money-management firm like mine. I can cut this cost substantially, however -- perhaps by $5,000 per month -if I agree to do enough trading at full brokerage commissions with certain firms that have office space available.” (Whitney Tilson, Investment Manager, 2004)

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Exercise 1

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A key reason for the cost advantage of “hard dollar” payments is the lower implicit cost of trading via non-intermediated ATS trading (23.0 bp versus 69.0 bp in case of bundled brokerage trading). Please calculate the level of implicit costs that would lead to a situation where fund holders would be indifferent between the “soft dollar” and the “hard dollar” payment (assume that in the hard dollar world the fund manager will be able to increase the management fees as outlined in the paper).

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Solution for exercise 1

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Two possible scenarios: • Scenario 1: In a hard dollar world the fund manager increases the management fee to restore his profit resulting from the soft dollar world (see Steil / Perfumo: The economics of soft dollar trading, November 2003)

• Scenario 2: In a hard dollar world the fund manager does not increase the management fee to restore his profit but keeps it constant (i.e. on the same level as in a soft dollar world)

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Paper Wrap Up - Figure 1

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Paper Wrap Up - Figure 2 (soft dollar world)

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Paper Wrap Up - Figure 3 (hard dollar world)

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Paper Wrap Up - Figure 4

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Solution for exercise 1

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Solution for exercise 1 – Scenario 1

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Y = Implicit costsBundled trading – Implicit costsATS trading

Soft dollar world 100 + Y + 24.5

Management fees

Hard dollar world =

Extra explicit cost (29.2 – 4.7)

118

Management fees

↔ Y = - 6.5 Implicit costs of ATS trading have to be 6.5 bp higher than the implicit costs of bundled trading Winter term 2007/2008

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Solution for exercise 1 – Scenario 2

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Y = Implicit costsBundled trading – Implicit costsATS trading

Soft dollar world 100 + Y + 24.5

Management fees

Hard dollar world =

100

Extra explicit cost (29.2 – 4.7)

Management fees

↔ Y = - 24.5 Implicit costs of ATS trading have to be 24.5 bp higher than the implicit costs of bundled trading Winter term 2007/2008

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Exercise 2

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You are Managing Director at an institutional brokerage firm and you are wondering what you need to do if the pressure of the fund holders would lead to a complete move to a “hard dollar” payment. In order to ease things, the assumption for this exercise is that you are the only broker in the world and you are providing both bundled brokerage and a non-intermediated ATS to your customers (fund managers). Furthermore you are also providing research and 3rd party analytics to your customers. Your cost situation looks as follows: Cost/revenue ratio for execution in case of bundled brokerage 50% Cost/revenue ratio for research 70% Cost/revenue ratio for 3rd party analytics 90% (quite high, as you buy it from external providers) Cost/revenue ratio for execution in case of non-intermediated ATS executions 40% Winter term 2007/2008

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Exercise 2

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a) Please calculate and compare your operating profit and your profit margins in case of the “soft dollar” and the “hard dollar” payment. b) In order to preserve your job you have to ensure that your profit margins remain stable in a “hard dollar” world. As you cannot influence the research and 3rd party cost/revenue ratios, the only parameter is to reduce costs on non-intermediated ATS executions e.g. by improving the technological efficiency of your ATS. Please calculate to which level you need to reduce your cost/revenue ratio of non-intermediated ATS executions in order to maintain the profit margin you had in the “soft dollar” world. Please take the concrete figures given in the paper as the basis for your calculations.

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Solution for exercise 2 a

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Soft dollar world Revenue:

$29.2 m (from bundled and ATS trading)

Costs: $10.8m*0.5 = $5.4 m for bundle executions $15m*0.7 = $10.5 m for research … $2.7 m for 3rd party analytics … $0.16 m for ATS executions Profit:

$29.2 m - $18.76 m = $10.44 m

Profit margin:

35.75 percent

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$18.76 m

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Paper - Figure 2

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Solution for exercise 2 a

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Hard dollar world Revenue:

$22.7 m (from ATS trading only plus research and 3rd party analytics)

Costs: $4.7m*0.4 = $1.88 m for ATS executions $10.5 m for research $2.7 m for 3rd party analytics Profit:

$22.7 m - $15.08 m = $7.62 m

Profit margin:

33.57 percent

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$15.08 m

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Solution for exercise 2 b

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Revenue (in a hard dollar world): $4.7 m + $18 m = $22.7 m

Revenue − Costs ! = 0.3575 Revenue ! Costs ! ⇔ = 0.6425 ⇔ Costs = $22.7 m ⋅ 0.6425 = $14.58 m Revenue We face unchangeable costs amounting to $13.2 m (for own research and 3rd party analytics), i.e. our costs for ATS executions may not exceed $1.38 m if the profit margin of a soft dollar world shall be restored

Cost ATS $1.38 m = = 29.36 % RevenueATS $ 4.7 m Cost/revenue ratio for ATS executions must be reduced from 40 % to 29.36 % Winter term 2007/2008

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BACKUP

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Figure 1

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Figure 2

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Figure 3

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Figure 4

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Figure 5

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Figure 6

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Figure 7

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