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Back in 1998, there was a Traders article, which stated that clearing remains a potentially lucrative business for well-capitalized broker dealers.
What is the state of the clearing industry in 2022? Does it remain lucrative? According to Brett Thorne, President of RBC Clearing & Custody, competitive pressures and the commoditization of trading services “keep margins thin”.
“However, with proper scale, the right technology – and perhaps just as importantly, the right people – clearing can be profitable for a well-managed clearing provider,” he said. Capitalization can be an important consideration, especially during periods of market volatility, he said.
Will Thomey, Co-Head of Business Development at Acadia, added that lucrative depends on perspective. Clearing businesses within many major financial institutions are viewed as important businesses to fully support their clients, but the profitability margins of these businesses are not always as lucrative as other areas, he said.
He added that more successful clearing brokers have invested in technical and operational capabilities to enable scale, pursue improving collateral optimization, understand the connections between how their franchise operates relative to their cost of capital, minimize client-specific arrangements (both commercially and operationally), and are capable risk managers (preventing potential loss from either default or operational errors).
“Tailwinds do currently exist for clearing businesses as macroeconomic conditions have led to higher trading volumes and increasing interest rates (which typically yields improvements to NII),” he said.
Clearing firms can generate a decent return on capital if done right, accordion to a a spokesperson at Apex Fintech Solutions. To succeed, requires a clearing firm to have great processing tools that can scale coupled with employee expertise to ensure regulations are followed and customer assets are protected.
“Firms will need to continue to innovate to give customers products and solutions that provide a frictionless investing experience.”
Back in 1998, a consolidation trend was observed in the clearing space. In 2022, 24 years later, consolidation is still a trend that seems to be a steady topic of conversation among broker-dealers, Thorne said. “Because the cost of doing business continues to rise, the burden of regulation continues to grow and the challenges of operating a broker-dealer continue to increase, we do not see the consolidation trend slowing down anytime soon,” he stressed.
Another related trend, Thorne said, is that many independent financial services providers are giving up their broker-dealers and switching over to the registered investment advisor (RIA) business model. “This is due to the very same pain points forcing broker-dealers to consider consolidation. So being able to provide custodial solutions is becoming a more important service for clearing providers to offer,” he said.
The forces at work that are driving consolidation and the shift to serving clients as an RIA are also fueling two employment trends seen throughout the business world since the start of the pandemic: the war for talent and rising cost for labor, Thorne said. “The clearing business depends on employees who have a highly specialized skill set.”
Thorne argued that the trend with the most wide ranging impact may be that “technology is playing an ever greater role” in daily operations and how services are delivered throughout the financial services industry.
“More than providing transactional support and maintaining books and records, clearing firms are becoming a go-to source for tools and systems,” he said.
Thomey agreed, saying that operationally, there is a more concerted effort to improve automation. As market silos continue to erode, firms realize that even though the Cleared OTC/F&O market has elements of standardization the operating environment should be simpler (especially relative to the non-cleared OTC market), he said. “However, the amount of investment in automation has trailed leaving disconnected infrastructures/processes/and limited workflow to digitize the interactions between Clients/Clearing Brokers/Exchanges/CCPs across trade (or position) management, margining, and settlement,” he said.
Additionally, Thomey said that given the macro-economic environment over the past several months, volatility has increased and risk management has re-emerged as a focus across the industry. “This includes looking at the level of margin/collateral held (and the affiliated Initial Margin models/calculations) as well as default management practices across the industry,” he said.
Challenges
The biggest challenge for CCPs is the continued demand for real time processing, a spokesperson at Apex Fintech Solutions said. “Not long ago, it used to take five days to settle an equity trade. Now we are down to two days and plans are in the works to get to one day by 2023.”
“We are also starting to see increasing demand for 24/7 trading in traditional markets – as it exists in crypto. The CCPs and clearing firms need to continue down the path of around the clock trading capabilities and near real time settlement, as this style of trading feels like an inevitability at this point.”
According to Thomey, a variety of challenges exist largely related to disparate data. A Clearing Broker has to contend with inconsistent data representations across Exchanges or CCPs without any form of standardization in relation to connectivity (e.g. the industry lacks standard APIs), he said.
“This presents challenges across trade management (getting trades properly executed, allocated, and cleared), ongoing books and records reconciliations, and the maintenance of reference data (instruments, risk arrays, etc.),” he said.
Moreover, according to Thomey, clearing firms are subject to different operating models required to post collateral at an Exchange or CCP. “This operational drag leads to suboptimal collateral allocation,” he said.
He added that replicating margin calculations is complicated (given differences across Exchanges/CCPs) which further complicates the ability for all participants to optimize risk and reduce related costs.
Thorne argued that responding to the technology changes happening in financial services is a “big issue” for many clearing firms. The challenge breaks down into three categories: cost, connectivity and competency, he said.
Developing new technology, adapting off-the-shelf technology and retiring legacy technology can all require a significant technology budget for financial services firms, Thorne said.
“The faster they need to accomplish a technology goal or the more complex the work to accomplish it, the more firms are going to need to spend. Clearing providers are looking for ways to help firms they serve control and reduce technology costs,” he said.
Thorne added that beyond the nuts and bolts issues related to developing technology is the challenge of how financial firms integrate new solutions into their existing technology stacks. Technology is meant to help make tasks easier and help improve outcomes, but if the tools don’t talk to one another, “technology can become a headache” for users instead of simplifying tasks for them, he said.
“Clearing firms need to offer technology platforms with flexibility to work with many different systems,” he added.
Thorne stressed that another challenge is the generational change on the horizon for the financial industry.
With retirements on the horizon for many key people in the industry, firm management will be transitioning to younger leaders and younger producers will need to get into this business, he explained.
“For these next generation firm principals and financial professionals, technology may be a determining factor in terms of who they choose as their clearing provider,” he said.
“They are looking for clearing provider technology that helps enhance their client relationships, such as planning software and mobile access to account information, as well as self-service capabilities that allow clients to more easily save, invest and spend money,” he added.
Enhancing the accessibility of clearing
As the securities industry continues to evolve, Thorne said that some clearing providers are shedding their smaller broker-dealers because they perceive the risks of serving smaller firms may be greater than potential revenue smaller firms can generate.
“In terms of enhancing accessibility, clearing providers simply need to do a better job of balancing the rewards with the risks of serving smaller broker-dealers,” he said
In support of this point-of-view, RBC Clearing & Custody works with smaller firms that are able to demonstrate a good track record of managing their business risk and running a clean business.
“Indeed, we believe there are many benefits of working with smaller broker-dealers. They can have high-quality financial professionals with fewer compliance issues because they know their reps better. In addition, many profitable smaller firms have competent staff where turnover is low,” he said.
A spokesperson at Apex Fintech Solutions said that enhancing the accessibility of clearing for introducing brokers, non-traditional companies and the retail investor themselves is done through providing a “frictionless experience”. Clearing firms that can provide turn-key and integrated platform solutions for these entities and their customers to make the experience seamless, level the playing field so that everyone can access the markets and have the tools to accumulate wealth, a spokesperson said. “That, combined with continuous education for those industry participants, will lead to a better experience.”
Thomey noted that Clearing Brokers (and to some extent Exchanges/CCPs) need to be well capitalized entities with adequate ‘skin in the game’.
“Improving accessibility should not be done if there are trade-offs (i.e. reduced or relaxed levels of margin and/or capital) or less oversight from global regulatory bodies,” he concluded.
