Institutional investors predict that half of their U.S. equity trading volume will be executed through electronic and portfolio trading systems by the year 2010, according to new research from Greenwich Associates.

The continued movement of trading business to these low-cost systems away from traditional single-stock transactions with broker sales traders is transforming the economics of the equity brokerage business, Greenwich says.

The amount of commissions paid by institutions to brokers on trades of U.S. shares declined 4%, according to its latest survey, even as markets set record highs. After holding steady at about US$10.8 billion in 2005 and 2006, total U.S. equity brokerage commissions slipped to approximately US$10.3 billion in 2006-2007.

Institutions cut brokerage commission payments by increasing the share of their trading volume executed through portfolio and electronic trading systems to 37% from 2006-2007 from less than a third the prior year, it noted.

“The institutions participating in our research predict that, as the use of new trading systems and technologies continues to increase, single-stock trades executed through broker sales traders will dwindle to just 50% of their U.S. equity trading business in three year’s time and to 46% among more active investors,” explains Greenwich Associates consultant John Feng.

The movement of trading volume to electronic trading systems from traditional high touch execution via broker sales traders has driven down average equity trading commissions, which were already on a path of steep decline. “All-in” blended commission rates for institutional trades across single-stock, program and direct-to-market electronic trades have fallen to an average of just 3.16¢ per share. Included in that average is the 3.8¢ per share weighted average commission rate on NYSE agency trades — down from 3.9¢ in 2006 and 4.0¢ in 2005 — the 1.8¢ per share average rate on electronic trades and 1.7¢ average for portfolio trades.

These declines have cut into commission revenues for equity brokers, which are reassessing their investments in equity research, Greenwich said. If these trends continue, institutions eventually will have to cut back on the amount of sell-side research and services they use, convince their brokers to continue providing the same content and service for less money, or find new ways to pay.

As Greenwich Associates consultant Jay Bennett explains, “U.S. institutions tell Greenwich Associates that their need for sell-side research is as strong as ever. If they want to maintain current levels of research quality and quantity, institutions will at some point be forced to consider new payment mechanisms such as direct hard-dollar payments, commission-sharing arrangements, and incremental ‘high-touch’ business specifically designated for research payment and add-on pricing to electronic or other low-cost business.”

Algorithmic trading is acting as the engine of growth for electronic trading in U.S. equities. “Algo” trading grew to 15% of U.S. equity trading volume in 2006-2007 from 10% the prior year, it reported. Looking ahead three years, institutions expect algorithmic trading to account for 23% of total U.S. share trading volume on a market-wide basis.

Algorithmic trading has been adopted by hedge funds as a favored means of execution. More than 85% of hedge funds use algorithmic trading strategies, as compared to roughly three-quarters of investment managers and mutual funds. “Hedge funds, which tend to take large positions and trade more actively than other types of institutions, are attracted to algorithmic trading by the anonymity and liquidity the strategies provide,” says Greenwich Associates consultant John Colon.