One thing is more certain than death and taxes in the arcane world of correspondent clearing: nothing stays the same.
Profound? Not exactly. Deep down, does it give consolation to the dozens of active trading desks scouring the nation regularly for larger broker dealers that will clear and settle their trades? Nope.
But the statement does underscore trading desks’ preoccupation with selecting the most suitable broker dealer, or correspondent clearing firm, to handle their business.
So how do trading desks pick the perfect partner? Is price-per- transaction a useful guide? Not really, some experts say.
“Ticket charges are usually left as opaque as possible,” said Lawrence Tabb, group director of The Tower Group, a Newton, Mass.-based securities-industry consulting firm. “In some cases, that leaves clearing firms room to charge as much as possible.”
Ticket charges typically include the cost of trade processing, margin-balance financing and frills such as extra customer reports.
“If your firm does not need a clearing firm that has international clearing capabilities, then it might be best for you to settle for a small clearing firm,” Tabb said.
What small clearing firms lack in size, they sometimes compensate for in areas such as personalized customer service and hand-holding. Some larger clearing firms, of course, would argue that they can do just as much. “Look at your needs first,” Tabb recommended.
Reforms
A plethora of regulatory reforms, pending rule changes and heavy-duty technology requirements are some of the biggest hurdles facing broker dealers, or introducing brokers as they are known, choosing a larger broker dealer for record keeping, trade financing, processing and other backoffice functions.
On the technology side alone, the large amount of capital tied up in robust computers that can process and record trades, track margin balances and short positions, and interface with the National Securities Clearing Corp. (NSCC) and the Depository Trust Company in New York, does not justify the cost for many small trading firms.
It is this large capital outlay that has pressured many trading desks in the past 12 months to discontinue their self-clearing operations and to sign deals with larger and better-equipped broker dealers.
“In the past 12 months, more self-clearing firms are signing agreements with clearing firms than the combined total of self-clearing firms that did so in the past five years,” said a senior executive with Correspondent Services Corp., the clearing unit of New York-based PaineWebber.
At the moment, several pressing technological hurdles are facing Nasdaq trading desks. One is the Order Audit Trail System, or OATS, made mandatory by the Securities and Exchange Commission on March 16. OATS is a real-time electronic system for gathering and reporting more than two dozen trade details for the NSCC.
To put that in perspective, OATS requires firms to install a system that can process and refine data faster than the current 90 seconds allowed for turning around the same volume of information. Desks will be required to provide the exact hour, minute and second of execution for each trade.
Aug. 1, 1999 is the deadline for sending electronic order data, while all manual or non-electronic orders must be covered by July 31, 2000. The first deadline is March 1, 1999, when orders received by electronic communications networks (ECNs), or at the trading desks of markets makers, must be reported via OATS.
Some firms, to be sure, will probably hum along smoothly in the new environment taking root. But these firms are most likely already equipped with the software requirements involved for OATS. Many others, however, are now mulling deals with clearing firms similarly equipped, or are eating up the costs with in-house systems.
The regulatory climate is unquestionably changing how clearing firms do business. Nasdaq trading desks say one of the biggest changes is the order handling rules. These rules have had a noticeable impact on how trading desks use electronic brokers, or so-called ECNs.
The rules require trading desks to disseminate an investors’ superior limit-order price-quote information to an ECN, to another market maker, or else have the order executed by the desk. The assumption that this would somehow result in increased business for ECNs is not quite true.
While ECNs overall have likely seen an increase in business, the proliferation of new ECNs has cut into the bottom line of long-established players.
At the same time, the cost of executing trades on ECNs has made them a ripe opportunity for progressive clearing firms. Bear, Stearns & Co., the parent of one of Wall Street’s largest clearing firms, is promoting a consortium-supported ECN, STRIKE, among its base of correspondent brokers.
Bear Stearns’ strongest marketing tool may be its pledge to charge substantially lower commissions on executions.
That, of course, could trigger a price war in the short term, but correspondents will not be complaining. “If it lowers our cost of doing business, that’s great,” said one Bear Stearns correspondent, smugly.
Internet Technology
The explosive growth in the use of the Internet on Wall Street for online trading, data distribution and other communications is another technological hurdle for some broker dealers. Firms that have not kept pace and lack the know-how, or do not find in-house systems cost effective, are turning to their clearing brokers for help.
In other cases, large clearing firms have developed state-of-the-art systems that are simply too elaborate for smaller broker dealers to replicate, never mind to ignore.
Pershing, the large Jersey City-based clearing unit of Donaldson, Lufkin & Jenrette, is touting its TelExchange, for example. TelExchange is an interactive voice-response system that enables correspondents and their clients to access real-time quotes and account information, as well as trade equities and options using a touch-tone telephone
Clearing firms distinguish themselves with their technology services. This is evident in how clearing firms report transactions to their correspondents, provide electronic access to their fixed income and equity products, and in the sticky legal domain of compliance.
Indeed, on the compliance side, a rash of electronic services are available. Philadelphia-based BHC Securities provides customized online reporting; PaineWebber’s Correspondent Services Corp. has a trade-monitor system; Chicago’s EVEREN Clearing Corp. has an online tracking system; and Pershing has ComplianceView, an online correspondent-controlled system for monitoring compliance activity.
Compliance
The correspondent clearing business has every reason to be focused on compliance, of course. With the stock markets booming and the Dow Jones Industry Average and Nasdaq composite index scaling new heights, it is not surprising that some stock fraud has been perpetrated by shady characters.
Although the scale of fraud is not believed to be pervasive, affecting the small-cap market and mostly involving a coterie of sleazy bucket shops, it has been enough to set off regulators’ alarm bells.
Correspondent clearing firms that cleared for these outfits were left with black eyes. Although the extent of how much they knew about the wrongdoing of their rogue clients is not exactly clear, the problems spurred the regulators to action.
Most importantly, this has resulted in rule proposals that could change how clearing firms must account for their clients. One of them is a New York Stock Exchange proposal requiring member firms to immediately send all customer complaints about introducing firms to the firm’s regulators, or “designated examining authorities.”
That could place new responsibilities on clearing firms for the conduct of their introducing brokers. Moreover, clearing firms would be expected to offer their introducing firms electronic tools to enhance compliance.
Another proposal would require the NSCC to take a more active role in detecting securities fraud. Under the proposal, the NSCC would get more information from clearing firms and pass on reports of alleged wrongdoing to regulators.
Some clearing-firm experts are skeptical about the rule proposals. “Basically, all the rules will do is clarify the relationship between the introducing broker and clearing firm,” one expert said. “The rules certainly won’t make clearing firms responsible for the practices of their introducing brokers.”
Best Practices
Meanwhile, the Securities Industry Association, spurred in part by the negative fallout from some well-publicized clearing-firm controversies, has formed a panel to develop best-practice guidelines in clearing arrangements.
The panel’s terms of reference include a wide-ranging review on the relationships between introducing and clearing brokers. SIA Board Vice Chairman Richard Pechter, who is chairman of the Financial Services Group of DLJ, will head the panel.
“Enhancing the public’s trust and confidence in the capital markets is our highest priority,” said SIA Chairman Irving Weiser in a prepared statement. “As part of our efforts, industry volunteers have been developing a series of best practices’ to help guide firms and educate industry employees in ensuring that the investor’s interests come first.”
Weiser said that the latest initiative will focus on securities-clearing arrangements.
Consolidation
Clearing remains a potentially lucrative business for well-capitalized broker dealers. Despite a consolidation trend that in the past few years saw the disappearance of some clearing providers, industry experts say there are still enough competitive survivors willing to do good deals with active trading desks.
Morgan Stanley, Dean Witter, Discover & Co., for example, announced earlier this year that it plans to exit its ten-year-old correspondent clearing business, which has cleared for more than 80 introducing brokers. (Morgan Stanley is also planning to sell its global custody business.)
On a smaller scale, Fiserev Inc.’s BHC subsidiary last summer beefed up its clearing operations when it acquired the clearing business of Stephens Inc. “A little research, time and patience can land a firm a good trading deal,” said one expert. “Don’t be afraid to pit one clearing firm’s deal against another clearing firm’s deal.
