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April 1, 2004

The Rapid Rise Of Outsourcing: More Firms Are Throwing In the Self-Clearing Towel

By Desmond MacRae

"Price is always an issue, but philosophically, we have decided that we're not going to be the cheapest deal on the street, but we'll offer the best service instead," says Daniel Son. Nine years ago, he and Phil Pendergraft founded Penson Financial Services in Dallas with nine employees and a handful of customers. Penson now has offices in three countries, 900 employees, and processes tens of thousands of transactions a day.

The key to survival in correspondent clearing is service, explains a Pershing official. With it,

scale can be earned. "Although our group clears for 1,100 broker dealers, we wrap each of our clients in a cocoon of service people, organized in dedicated relationship teams," says Michael Row, a managing director in Pershing's National Customers Group. These teams can provide everything from day-to-day service on any product their customers offer, to training and Website development and enhancement. Service, in fact, is how correspondent clearing firms that are not giants, differentiate themselves.

Another survival technique is to specialize in serving specific types of customers. "We don't currently clear for any mutual funds," says Penson's Son. "We look for other types of customers."

One client that correspondents seek is a very active retail trader like CyberTrader. After they were bought by Charles Schwab, Penson continued to clear for CyberTrader which has some 25,000 accounts that generate 50,000 to 60,000 trades a day.

The ratio of trades to accounts in brokerage firms with traditional accounts is much different. Schwab, for example, has some eight million customers who record about 200,000 trades a day. Smaller traditional brokerage firms have the same ratio of total customers to daily trades.

Banks now offer great opportunities, National Financial's Malo says. "All of a sudden, banks have multiple segments high-net-worth, ultra high-net-worth, and trust departments," he adds. "Banks are no longer a one segment market of brokerage arms they have acquired."

Another new type of customer is the black box investment manager who uses computer programs that can sometimes automatically generate as much as 10,000 trades a day. This customer type is very keen on straight-through processing (STP), as are ECNs which are another type. There are also small firms with 20 to 50 employees serving hyper-traders (aka day traders) which, like black box traders and ECNs, need services as close to STP as correspondent clearing firms can get.

The Professionals

Then there are listed traders, professionals and semi-pros, who trade on the NYSE DOT system. Finally, there are insurance broker dealers who need a lot of ancillary services, but do less volume.

Firms that are not goliaths tend to concentrate on particular types of business. An example of this is Spear, Leeds & Kellogg, which is institutionally oriented, and does not court retail. Most customer segments depend on super-fast front-end execution systems they can plug into without being forced to conform to their clearing firms' systems. Many want to white label' their clearers' systems so that end-users can seamlessly access what they need on their own brokers' Websites.

Clearers report that all of their customers are asking for immediate access to trading activity to satisfy regulators.

"Demands by regulators for reports seem to be almost a daily event these days," National Financial's Malo says. In short, customers want it all, just as they always have. "Technology is a major factor in our business, but customers want to use their own protocols," Penson's Son adds. "They want good product capabilities, but they also want great pricing."

What is clear is that correspondent clearing, despite all the consolidation, is not exactly the commoditized business many casual observers once considered it. Sure, electronic processing is a little like electrical screwdrivers in many ways they are all pretty much alike. However, the key to success for correspondent clearers lies in how deftly and efficiently they can use their own industry tools, observers note.

"Our strategy today, listening carefully to customers and continuing to innovate for them, is no different than it probably ever has been," says Row at Pershing. "You're never done, and you will never have the perfect model that will work forever."