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July 31, 2004

Has Self Clearing Become A Profit Margin Headache?

By John Hintz

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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.