Brokerage firms that choose to clear their own trades have long viewed themselves as the industry's mavericks, taking on the often cumbersome back-office responsibilities of collecting and maintaining transaction-related data in order to provide their customers with quick, hands on service. That independent streak, however, has eaten deeply into their pockets in recent years, making the back-office more of a profit margin headache than benefit. The back-office dilemma is making fully disclosed relationships with a clearing firm more attractive, a prospect that has been further sweetened by clearers' efforts to make their correspondents feel more like they're still self-clearing.
The last four years have been painful for the brokerage industry as whole. Beyond the seemingly never-ending goal to achieve straight through processing by automating their business systems, brokerage firms have had to bolster their business continuity plans following the Sept. 11 attack, and they've faced a slew of new regulations. Many of the new regulations followed the collapse of Enron and other corporate scandals, but new regs, such as proposals for new mutual fund point-of-sale disclosures and short sale rules keep coming down the pike.
"Over the last year the industry has had to comply with a large number of regulatory initiatives, including the Patriot Act, anti money laundering legislation, and OFAC Reporting, that many believe will continue as the scrutiny placed on the financial service industry continues," said Marc Zutty, senior director at U.S. Clearing.
Every new rule and requirement inevitably becomes an additional task that a brokerage firm's back-office crew must attend to by upgrading the firm's systems or contracting a solution with a third-party provider. In the 1990s, when the stock market climbed steadily higher and commission revenues flowed like wine, additional back-office costs were easily covered. In fact, the back office was largely a fixed cost that made every additional trade that much more profitable. The last four years, though, have been anything but steady, and brokerage firms must increasingly find ways to retain existing customers and their assets. That means devoting more resources to the customer and less to the back-office, especially as that fixed cost continues to grow.
"People are recognizing that the way we make money is through collecting assets, the sheer number of transactions … but they've had to lower their ticket charges to remain competitive. The only way profit margins have remained strong is by doing a greater volume of business," said Norm Malo, president of Fidelity's National Financial clearing unit.
Devoting resources and time to back-office issues, however, takes away from that effort. For example, National Financial was one of the many clearing firms and broker-dealers directly impacted by the Sept. 11 attack. It worked with its correspondents to recover from the tragedy and set about building a business continuity platform stretching across the Northeast, an investment that few but the largest Wall Street firms could afford to implement. The regulators have pushed all securities firms to bolster their own back-up systems, but that's less of an issue for National Financial's correspondents, since their clearer has already done it for them.
Although the stock market had already begun its decline, Sept. 11 marked the beginning of the ensuing years of market turbulence. A month later, that turbulence capsized MJK Clearing, a smallish clearing firm that was caught on the wrong end of a doomed stock loan transaction, sending its 40-odd correspondents into a tailspin. The MJK incident displayed the need for clearers to have enough capital to withstand market upsets, and, along with the necessary regulatory- and STP-related investments, the brokerage industry became a far more capital intensive industry.
The industry has also continued to become more global, as investors seek to diversify their portfolios overseas, another costly endeavor. Some clearers have taken concerted steps to gain access to foreign exchanges, providing broker-dealers with the ability to clear and execute trades as smoothly and efficiently as possible in non-U.S. markets.
"We offer an integrated clearing process in multiple marketplaces, products and currencies, all on one platform," said Dan Son, president of Penson Worldwide. He added, "In the fourth quarter, we're launching the ability to have cross border executions to Europe through our London execution hub"
The broad array of costly industry trends today has pushed many self-clearing firms to consider a fully disclosed relationship with a correspondent clearing firm. Robert Iati, research director at the TowerGroup, says that about 25% of brokerage firms were self-clearing in 1999, a portion that's fallen to 17% today, or about 900 out of approximately 5500 firms.
The move to a fully disclosed relationship removes many of the headaches confronted daily by a self-clearing firm. No more back-office clerks to train and maintain; a smaller IT department and a much smaller technology bite out of the brokerage firm's budget; and a partner with whom to tackle the new regulatory burdens. The move may lessen the correspondent's perceived independence, but it also frees up its resources to focus more on dealing with customers and selling financial products.
"Many of the entrepeneurs running self-clearing firms find themselves spending more time, effort and resources on things that are not related to client relationships and business opportunities, and instead are more technology, operations and products oriented," says Mike Row, a managing director in Pershing's National Customers Group.
A fully disclosed relationship can also give the brokerage firm greater freedom to deal with front-office issues.
"Utilizing a clearing firm allows the broker dealer to concentrate what may be limited resources and capital on their core business: servicing clients," says Linda VanOosting, vp at Raymond James' clearing unit.
In the case of Pershing, it provides its correspondents with marketing and branding support, as well as tools such as its recently launched eAnalytics, which allows correspondents to shift through their own customer-related data to analyze productivity and business strategies.
Fully disclosed relationships allow brokerage firms to tap into the economies of scale of their clearing firms, which in turn have merged at a record pace in recent years to improve their own economies of scale and capabilities to deal with the industry's challenges. Pershing, for example, was purchased a year and a half ago by the Bank of New York, which merged the clearer with its own clearing unit. Fidelity, meanwhile, purchased UBS PaineWebber's Correspondent Clearing Services, and recently RBC Dain announced that it was purchasing Wells Fargo's clearer.
In a more unusual acquisition, securities processing firm Automatic Data Processing acquired two clearing units that Bank of America sold following its acquisition of Fleet Financial. Clearing firm sources speculate that ADP made the bold move outside its core processing business because so many of its self clearing clients that used its processing software had decided to give up their back offices in favor of a correspondent relationship. Those firms were holdouts in terms of wanting to retain control over their customers accounts and the ability to customize their customer services, including the design of such basic broker account elements as customer statements. But the ever-growing back-office cost persuaded them otherwise.
"There are so many things coming down the pike that the fixed expense [of a back office] is just going to keep ratcheting up," says Mike Kavanagh, president at RBC Dain Correspondent Services. "Equally important is the continually evolving product array, reporting requirements to deliver products to clients, a quality workstation, online Internet tools, and the list goes on."
Clearings firms have also worked hard at helping self-clearing brokerages overcome their fear of giving control of their data to a third party. Even four or five years ago, self-clearing firms were loathe to send their customer-related data to a clearing firm where they would have to call up a clearing rep to order a report on their sales frequency of a certain product, their asset retention, or some other aspect of their businesses. As self-clearers, they could simply walk down the hall to the margin or cashiers desk to get the information. In addition, they were concerned that correspondent clearers would not be able to provide customized information that self clearers were used to.
"For many years, firms were reluctant to go into a fully disclosed relationship, mainly because they were afraid of getting standard information on the reports that were received by all the clearing firms' correspondents," says Paul Vinton, an evp at SWS Securities' holding company.
Vinton says his firm now provides more than 100 reports to correspondents and it can provide specialized reports as well. Even more importantly for self-motivated broker-dealers, however, is that Southwest Securities provides its correspondents with direct access into its database.
"They can access information just like any of our technology people, and they can ask the most arcane questions they want and get the answer," Vinton says.
Today, clearers' intent is to give correspondents more control over their businesses. Pershing has implemented a so-called rules engine that, for example, allows correspondents to set up parameters for when certain types of trades are pulled out of the automated trade execution process because they fail to meet established criteria, and those trades are sent to principals for review. The clearing firm's rules engine was initiated five years ago with 20 or so rules and now its approaching 200, Row says. In addition, the rules engine is moving beyond trade-related activity to other customer-service functions.
"We're starting to apply the rules to things like check requests and responses to tender offers, so firms are less burdened and these activities are done in a very automated fashion if they pass the rules," Row says.
Control can take other forms as well. Al Beale, Fiserv's national sales manager, says his firm's independence from a broker-dealer parent allows it to work closely with a correspondent in whatever capacity the customer deems most appropriate. A self-clearer could choose a fully disclosed relationship. Or Fiserv could perform a more comprehensive role as a clearer and third-party marketer, staffing the correspondent with reps. Beale said clearing customers also have the option of later turning self-clearing by using Fiserv's customized core processing system, or a larger broker-dealer could establish a Fiserv-staffed middle-office to service its reps more effectively, and that middle-office would in turn be serviced by Fiserv.
"A broker-dealer can choose the appropriate delivery model: what's best today, and as the business changes and grows it can choose another solution inside the same technology framework. It's not locked into one solution at one firm," says Beale.
National Financial is taking control to the rep level when it launches a new version of its workstation in August. Assuming a rep's home office permits it, the rep will be able to review and analyze his own book of business, directly from his workstation.
"If you want to see all the accounts in which you have IBM stock, you can see that instantaneously. In a self-clearing environment, you would probably have to go through the back office," Malo said, adding that such technology is bringing correspondent clearing and self-clearing environments ever closer together. Malo says, "We want to give the correspondent the flexibility of looking and feeling like its self-clearing, but also give the client the choice of outsourcing what it doesn't want to do back to us."
