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Tim Quast
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May 26, 2005

The Rocky Regulatory Road: Survival of the Small Broker Dealer

By Nina Mehta

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  • The Rocky Regulatory Road: Survival of the Small Broker Dealer

The regulators' push to clean up abuses in the brokerage industry is having an unexpected result - it is hurting the smaller brokerages, many of which are now struggling to survive. "For many smaller brokers, the challenge is to keep up with the avalanche of rules and regulations issued in the last few years," says William Alsover, Jr., chairman of Centennial Securities Company, a full-service broker dealer in Grand Rapids, Mich. "This has caused severe strains."

Regulators are responding to widespread scandals, ranging from research-related conflicts of interest, to undisclosed compensation for mutual fund sales and improper IPO allocation practices. The result is that new rules and regulations have rained down on broker dealers from Congress and federal agencies.

Last year, the NASD issued rules requiring certain supervisory controls and procedures as well as certification for chief compliance officers of those systems. (The NYSE's Rule 342 accomplished the equivalent for its member firms.) Earlier in 2004, both self-regulatory organizations mandated business continuity planning programs to ensure broker dealers have back-up plans for their mission-critical operations.

The USA Patriot Act of 2001 required new anti-money-laundering compliance programs. More recently, the SEC's books and record-keeping amendments to the 1934 Securities Exchange Act - Rule 17a-3 and Rule 17a-4 - prescribed a range of document generation and retention procedures that are difficult for some firms to manage effectively.

"The SEC and NASD have taken a very adversarial regulatory stance," says Leo Guzman, president of Guzman & Co., an institutional brokerage firm in Coral Gables, Fla. "Some of the consolidation among smaller and medium-size firms is driven by the need to comply with ever-more-stringent regulatory requirements, which at the end of the day don't make much economic sense and don't protect investors."

An example is business continuity planning for an agency brokerage operation. Guzman points out that his institutional firm must have highly reliable execution systems during the trading day. "But given the nature of our business, a full contingency plan doesn't make any sense," he insists. "We shouldn't have to have the same requirements as a Charles Schwab."

The problem for many small trading firms isn't confined to a particular set of rules. Instead, it's the escalating pile up of compliance requirements. "When I started the firm in the late 1980s, regulation seemed aimed at determining whether you were conducting an honest business under the rules," Guzman says. "Now regulation is a book of a thousand gotchas."

Barriers to Entry

Another trading executive concurs. "The business is becoming more regulatory-based. [This presents] new barriers to entry that will discourage people from entering the industry or will force people to change their models," says Robert Robotti, chief executive of Robotti & Co., an agency brokerage in New York. Nonetheless, Robotti views regulatory compliance as the cost of doing business. Institutional brokerages, trading and market making operations, as well as small retail-focused brokers, are in a period of consolidation. The larger trading and research firms must distinguish themselves in order to compete with full-service wirehouses.