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March 1, 2000

Preparing for Correspondent Woes: Correspondent Clearing Firms Shoulder the Burden of Trade Process

By John A. Byrne

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  • Preparing for Correspondent Woes: Correspondent Clearing Firms Shoulder the Burden of Trade Process
  • Page 2

One challenge for small and medium-sized broker dealers making markets in stocks may seem a tad surprising: finding a larger broker dealer willing to clear and process their retail and institutional trades.

The reason: Firms that introduce their stock trading business to a larger broker dealer - known as a correspondent clearing firm - involve them in the potential risks for a default in the clearance and settlement chain.

In the clearing industry, a regulatory black eye for an introducing broker can bruise a clearing firm as much as the correspondent, and cause both sides financial pain.

To be sure, most introducing brokers likely conduct their transactions in a manner beyond regulatory reproach.

But as the stock market swells with rising volume and online casino trading contributes to institutional and retail sectors reeling with volatility, the backoffice clearing providers are aware of the risks they have assumed. And those risks can be huge.

With margin debt as a percentage of total stock market valuation reaching a level not seen since just before the market crash in October 1987, a sudden correction could conceivably put clearing firms on the hook if margin calls are not satisfied.

To this end, the Securities and Exchange Commission has joined forces with the National Association of Securities Dealers to scrutinize the lending practices of about six clearing firms. The regulators clearly want to avoid a repeat of the bankruptcy of a venerable New York clearing firm, which was brought down by an introducing broker in 1995.

This is not a subject execs at clearing firms are comfortable discussing, but some privately admit that lending practices worry them.

Still, clearing experts say the issue should not be overblown.

In a cash account, meanwhile, the only risk a clearing firm has is between the clearing and settling [time] of a trade, explained Henry Minnerop, a partner at New York-based Brown & Wood, a securities law firm that represents clearing firms.

"But even that risk," Minnerop added, "is minimized because the trades are cleared [by the National Securities Clearing Corp.] which becomes a guarantor for the counterparties [on trades]."

Minnerop said he would be very surprised if a market correction caused significant harm to clearing firms lending on margin, but adds that he can only speculate on this sensitive matter.

Evolution of Clearing

Clearing has come a long way since its incarnation as a way for firms to outsource a high-fixed expense in the aftermath of the paper crunch in the mid-1960s. Later, correspondent clearing became even bigger business with the deregulation of fixed minimum commissions in 1975.

Correspondent clearing remains a massive business, driven in large part by volume. The top-tier firms reap proportionately more once they have covered the fixed overhead costs of their operations. Achieving that economy of scale initially requires a lot of capital. However, while the top-tier providers may put up a strong fight for an introducing broker's accounts, it is not always about scale and capital.

"A correspondent is buying into your backoffice," said Steve Samberg, head of correspondent clearing operations at Dallas-based First Southwest Company.