Profits slumped unexpectedly in the Canadian securities industry in the first quarter of 2005, with small independent firms facing particularly tough times, the Investment Dealers Association of Canada said today.

Higher compensation paid to staff and a decline in equity trading revenue were the big reasons for the drop.

In its quarterly publication Securities Industry Performance, the IDA said industry operating profit was $1.1 billion, down 1% from the prior quarter and 9% from a year ago. “While profit remained at relatively lofty levels, the quarter’s slowdown was a bit of a shock,” said IDA report said

“After all, the seasonal RRSP phenomenon should have helped bolster the industry’s momentum and, ultimately, profits. Instead, the bottom line fell short of expectations.”

The IDA report said that the, “wobbly equity market, lackluster trading and rising expenses played a major role in crimping operating profits in the quarter”. The S&P/TSX Composite Index was up 4.3% in the quarter, but investors were not similarly exuberant the IDA notes. “Mounting investor worries over rising oil prices, interest rates and a questionable corporate profit picture not only fueled market volatility, but limited the upside returns in the quarter.”

As a result, proprietary trading revenue slowed sharply from the banner fourth quarter. Equity trading revenue came in at just $103 million, down 55% quarter-over-quarter and 60% year-over-year. Bond trading revenue topped $177 million, a gain of 26% quarter-over-quarter and 57% year-over-year.

Rising expenses was also a large contributor to the quarter’s downturn, the IDA points out. Total expenses reached $2.3 billion in the first quarter, a rise of 6% quarter-over-quarter and 7% year-over-year. It reports that the growth in expenses was underpinned by an 18% quarterly increase in contractual payouts such as commissions and bonuses to professional staff.

The bright spots were higher commissions, up 16% from the prior quarter to $1.4 billion, and new equity financings climbed 4% in the quarter to $707 million, a 21% jump over the same quarter in 2004.

The IDA report says that the independents – the small, boutique retail firms – were particularly hard hit. In the first quarter, operating profit for the introducers tumbled 42% quarter-over-quarter and was flat for the full-service retail firms. For institutional firms, operating profit was down 12% quarter-over-quarter. The integrated firms actually posted a 6% profit increase.

Higher expenses were the big drag on profits for the independents, the IDA notes, partly due to their fast growth over the past couple of years. Employment in the introducer group is up 67% from 2001, versus just 9% for the full-service retail firms. “The retail firms have been aggressive at luring industry experts over to the retail side with lucrative incentive packages. The plump bonus and paychecks to attract and retain industry experts were not cheap and reflected in the group’s higher expense account,” it notes.

Looking ahead, the IDA says the industry may be on a slower expansion path in the coming months. “An increasingly tougher market will only add to the industry’s current challenges. Earnings will likely remain under pressure while costs continue to drift up – not an attractive scenario. Undoubtedly, a tighter squeeze on profits will impact firm performance and expansion.”

Markets are facing the usual summer lull, uncertainty surrounding oil prices, interest rates and corporate profits. “All this could keep the markets in a range-bound in the coming months until some uncertainties begin to lift,” it suggests, adding that the small retail firms may experience increasing difficulty in recruiting staff under more difficult market conditions. “The appeal of an entrepreneurial environment and golden incentive package may give way to the comforts of working for a well-established, large institution when times are less bullish.”