Small dealers still feeling the squeeze

In late January, the Investment Industry Association of Canada (IIAC) released its latest quarterly data, which show that the securities sector did enjoy a bit of a pickup in the third quarter (Q3) of last year, ended Sept. 30, 2012, with overall sector profits at $577 million – more than doubling from both the previous quarter (Q2, ended June 30, 2012) and Q3 2011.

However, it was only the integrated dealers and foreign institutional firms that made money in Q3 2012. The best that the smaller Canadian dealers managed to do was to pare their losses – a situation that has the IIAC worried about the looming extinction of these small firms.

In a letter to IIAC members, Ian Russell, president and CEO of the IIAC, notes that small firms are under increasing pressure amid the unprecedented slump in markets and relentlessly rising costs.

Although all securities firms may be facing similar pressures, the situation is particularly dire for small dealers, which have less margin for error. As Russell notes in his letter, fixed costs represent a higher proportion of overall expenses for smaller firms – and their margins are tighter because of their smaller size.

Indeed, the latest data highlight the continuing struggle facing small dealers. The profits for the domestic integrated dealers as a group almost doubled in Q3 (from both Q2 2012 and Q3 2011) to $590 million. Foreign institutional firms also managed to grow their profits to $26 million in Q3 from $16 million in Q2 2012 – although this was still down from $32 million in Q3 of 2011. In contrast, the retail firms and domestic institutional boutiques were still in the red in Q3 2012.

Larger firms better off

Collectively, Canadian retail firms lost $13 million in Q3 2012. Although that is an improvement over the $29 million they lost in the previous quarter, almost all of the recovery within the retail segment was at the larger, full-service firms.

The larger retail investment dealers cut their losses to $6 million in Q3 2012 from $21 million in Q2, the IIAC reports. This improvement was primarily due to a turnaround in their trading businesses, which swung to $14 million in positive revenue in Q3 from a loss of $10 million in Q2. Furthermore, these larger dealers also trimmed their operating expenses by about 4% quarter-over-quarter.

By contrast, the small, retail dealers barely managed to improve their standing. They recorded a collective $7-million loss in Q3 2012, up from an $8-million loss in Q2. And although every other segment of the securities sector managed to increase operating revenue in Q3, these firms saw their revenue continue to decline – down by 3.6% from Q2 and off by 22.5% from Q3 2011.

@page_break@ Some of this revenue decline surely reflects the attrition that already has taken place among these firms. The number of retail dealers has dropped to 74 from 81 over the past year. As a result, the head count is down to 5,625 employees from more than 6,000 – and productivity (as measured by revenue per employee) continues to decline.

Indeed, the IIAC reports that this erosion among the small dealers has been going on for several years now. About 30 small- and mid-sized dealers have disappeared over the past four years, most of them being acquired by other firms in the sector. And absent a substantial turnaround in market conditions, the IIAC expects this trend to continue, with “an acceleration of firm closures, amalgamations and acquisitions” likely to be in the cards.

At this point, there are few signs that the storm is over for the securities sector. Full-year data for 2012 won’t be available until the end of February, reports Jack Rando, the IIAC’s director of capital markets. In the meantime, he notes, these latest results “lend further support” to the IIAC’s concerns about the survival of small firms.

“The cost burden on small and mid-sized firms is becoming increasingly problematic,” Rando says. “These firms can only bear so much and, in the absence of a strong market recovery, will have to keep all options open for weathering this storm.”

For now, indicators suggest that these smaller firms are facing continued headwinds, as activity in major business lines was either flat or down in 2012.

The latest data on the Canadian underwriting business from Toronto-based Thomson Reuters Corp. show that equities issuance slipped in 2012 (with total proceeds for the year down by 0.3% from the previous year), while overall debt issuance rose by just 2% during the year.

Small firms hit hard

Moreover, data compiled by Toronto-based ITG Canada Corp. show that about three-quarters of the firms trading in Canada suffered year-over-year declines in both the volume and the value of their trading activity in 2012.

Some of the sector’s small firms were hit particularly hard in their trading business. Although the five big, bank-owned dealers all saw their year-over-year trading volumes decline by between 22% and 25%, about one-fifth of the sector’s firms saw their trading volume drop by more than 50% during the year, ITG’s data reveal.

All of these data point to continued consolidation, which, the IIAC warns, not only reduces competition in the sector, but also can have other harmful consequences for both markets and the economy.

Russell warns that as boutique firms disappear, services for underserved market segments may be reduced as well: “The demise of the small dealer will limit consumer choice for wealth-management services, aggravate the already difficult financing problem for small and mid-sized companies and erode the liquidity of venture and [Toronto Stock Exchange-] listed shares.”

To prevent such problems, Russell suggests that small firms are going to have to continue to adjust – by cutting costs further and trying to gain scale.

However, the IIAC also would like to see the regulators help ease the pressure on these firms by minimizing the compliance burden and providing greater regulatory flexibility for smaller players.

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