With portions of Basel III set to go live in within the coming year, smaller broker-dealers could be unaware that they are in the crosshairs of the new rule. In short, the clearing firms used by independent broker-dealers are facing increased liquidity requirements. Traders recently spoke with CFA and director of research Tom Burnett and Sean Kelleher, president of Wall Street Access, a mid-size broker dealer. Are IBDs with less than $5 million on their balance sheet ready for Basel III? The prospects arent good, says Wall Street Access: hundreds of smaller IBDs could go out of business – and many more traders could lose their jobs – over the next 6 to 18 months as a result of this issue alone.
Traders: What are the projected impacts on U.S. firms of Basel III?
Tom Burnett: It is addressed primarily to the money center banks and financial services institutions with at least $50 billion in total assets. Think of it as covering the larger financial services and lending companies in the U.S. and overseas with operations in the U.S. The structure of Basel III is to impose mandatory minimum capital ratios and a new concept called the Liquidity Coverage Ratio. It would require that these institutions require a certain amount of liquidity on their balance sheets at a moments notice depending on their risky assets and their cash flows from the assumed next 30 days.
The most important feature is that it has already gone into effect at the end of 2015 – and it is going to be phased in even more dramatic form. The first requirement was 60 percent and it goes up 10 percent each year until 2019. But the big firms, the banks and the big lenders, are in their minds already subject to it.
Traders: Could you explain what Basel III also means?
Burnett: The subject of Basel III, these rules and liquidity requirements, are forcing the big lenders who are clearing banks for independent broker dealers, as they have to live under a more tightened capital structure, they are imposing new limits on their independent broker dealers for whom they clear.
Thats where we are going to see movement this year. As these Basel III rules impact the large clearing bank, the clearing banks decide that they need to have more capital put up by their customers, their independent broker-dealers, that will lead to significant changes within the industry.
Traders: How many smaller broker-dealers are we talking about?
Burnett: We conducted our own survey. We looked at the FINRA and SEC databases, and we simply asked for all the FINRA broker-dealers with $2 million in net capital or less who are located within 5 miles of our downtown zip code here and we came up with more than 200 names. We believe there is a huge universe of independent broker-dealers out there that will be negatively impacted by the Basel III waterfall as it begins to impact, the big clearing banks will be asking their clients, the independent broker dealers to put up more capital.
Traders: Now its not just retail banking, its wholesale institutional investors, correct?
Burnett: Yes. I think the $50 billion threshold is the definition in the U.S. I dont want to say that that works for the Europeans but thats the benchmark we have been told to look at here.
Traders: When you say find a clearing firm that isnt subject to these rules, what does that mean? Is that just a loophole that they could exploit or is this something that is actually an option that is ethical and aboveboard?
Burnett: There are a number of clearing firms out there that are not at the $50 million asset threshold. Theyre not registered as banks with the Federal Reserve, theyre financial service institutions, theyre totally aboveboard and ethical. However, the clients for the independent broker-dealers may resist opening accounts with their broker-dealer once they find out that the broker-dealer has gone to a smaller, less well known or less well established clearing firm.
So there are risks here. If Im an independent broker dealer with a big, well-known bank, and that bank asks me to put up more money and I can go find one of these smaller clearing firms that will not require that, I can do that. Thats ethical and legal, but many of my clients will opt or may opt not to go with me because they want to see a bigger clearing firm behind my trades.
Sean Kelleher: For introducing broker dealers, the number firms are going to have a hard time with is if the clearing firms want to see $5 to 10 million in net capital. If youre one of these big money center banks, thats going to be a real hurdle.
Burnett: Most people dont realize how many small independent broker-dealers are out there. If we ran these numbers using a $5 million net capital base wed probably come up with 300 or 400 firms. If weve got 200 operating at $2 million or less we can find another couple hundred if we took it all the way up. Theres probably 400 or 500 firms out there in the New York area with less than $5 million in net capital. That is a real important story, because they have employees, traders, and customers. There is going to be a shakeup and a lot of turmoil this year as Basel III impacts the clearing banks.
Kelleher: And youre talking about small firms that have thrived on Wall Street for many years, in many cases these are family-owned and operated firms. Theyve played by the rules up until now, this whole concept of too big to fail seems like its now been changed to too small to survive because these capital requirements are going to make it increasingly more difficult for the smaller boutique operation to survive.
Traders: So what are some of their options? Do they band together, look for an infusion of capital, or do they reorganize their money so that they can cover some of these clearing operations?
Kelleher: We are having strategic discussions now with several of the smaller broker-dealers who have net capital thats under $5 million and we think that that is one very possible scenario where we look to do something together strategically. We believe that that is going to be a scenario that does play out with other firms, as well.
Burnett: There are limited choices. You either put more money in, you find a strategic partner, or you fold your operations into a stronger balance sheet. Theres really only three ways to go here, but, its the direction coming from the big clearing firms. This thing isnt just coming out of thin air, and Basel III doesnt directly impact any of the independent broker dealers, their balance sheets are well below the $50 billion threshold, its just the impact on their clearing bank that is what we think is going to have a very highly leveraged impact down the road.
Traders: What steps are the smaller firms taking?
Burnett: Based on the conversations we have, theres a lot of dialog in the industry now. We think that the independent broker-dealers, while they may not have been aware of Basel III per se, because they are being told by their clearing firms, hey, we have to put up more money, we have to put up more liquidity, therefore youre going to have to do it. Thats how Basel III is being communicated down to the independent broker-dealers and we think these conversations have started and are going to be ramped up across the industry throughout the rest of the year.
Kelleher: But there are still many boutiques introducing broker dealers who arent aware of this.
Traders: Do they think that theyre exempt?
Burnett: I think because everybody knows about The Dodd-Frank Act and the Volcker Rule and everybody is focused on how the Fed had to save the world after Lehman and AIG and Bear Stearns and all these problems. There is quite a bit of focus domestically, I just dont think that theres a realization of how global the regulatory intent is.
Kelleher: I would say that the clearing firms are in the process of speaking to their introducing broker-dealers who have to answer to this, why theyre being asked to put up more net capital or find another alternative. I would say the conversations are beginning. Theyre starting to have them and I think that they will be having many more to come.
