Survival of the Smartest

What clearing and self-clearing brokers must do to survive and how you know it isn't worth the effort

Time to pull the plug on the back office?

The deathwatch and the questions never stop in the clearing industry. Which broker-dealer is next to go? And which firm is next to decide clearing is too much for it, because it takes up too much time and resources and poses too many regulatory dangers?

It is a consistent theme in the clearing business of late: Firms that stop self-clearing. Firms that stop clearing for others. Firms that just stop operating.

“I know lots of clearing brokerages in this business that are barely holding on,” said one industry executive, who declined to be quoted by name.

An industry observer says the costs of the business, which have been consistently rising at a time of increased regulation and declining margins, are forcing most clearing firms to think seriously about long-term strategy.

“Brokerages, especially smaller ones, are under an increasing amount of pressure to think about if they should continue to self-clear,” said Doug Dannemiller, a founder and principal of LaRoche Research in Duxbury, Mass. Dannemiller knows dozens of brokerages that fall into this endangered group.

And the pressure has been going on in the clearing brokerage business for the last decade, with many asking which clearing brokerage will be the next to go and which will decide to stop self-clearing.

The number of brokerages that clear for themselves and others has dramatically declined. Over the past 15 years, the number of firms that clear for others has dropped from 125 to fewer than 20 today, according to Baltimore-based industry consultant RM Associates. At the same time, the number of firms that clear for themselves has also declined-the number of self-clearing firms has dropped to around 270, according to Sanjiv Mirchandani, president of Fidelity Investments’ National Financial.

Mirchandani predicts it is inevitable that self-clearing firms will continue to decrease. Although Dannemiller says the number of self-clearing firms probably hasn’t gone down that much over the past few years, he agrees that the number of firms that clear for others has declined. And he added that the pressure on self-clearing firms to re-evaluate their back office operations “is huge.”

Another industry analyst concurs.

“Those firms will face a lot of pressure. There will be fewer firms that self-clear,” said Alois Pirker, research director for the Aite Group. Citing the pressures of increasing costs, he also believes the number of self-clearing firms is going to decline. Pirker says the problem for small to midsize broker-dealers-firms that can’t achieve the economies of scale enjoyed by the biggest firms-is both regulatory and competitive.

“These kinds of firms can’t keep up. They can’t find ways to improve their platforms. They can’t afford the regulatory costs. They can’t figure out the best account opening services,” he said.

Yet in the worse of circumstances, with low volume and poor margin business, some firms will still pull through. And some will even prosper, industry observers say. But which ones should give up their back offices and which ones can muddle through?

Experts have an idea of who the clearing industry survivors will be. These will either be huge firms that can achieve economies of scale or that can justify a back-office expense because it supports some other part of the firm.

To determine whether they fall into one of these favored categories, industry observers say, clearing brokers must answer some basic questions: Are their clearing services, and all the aligned investing and regulatory services that go with them, worth the time, effort and capital? And why is offering clearing functions still worth the effort?

Those were some of the questions recently posed by CQ&D in a series of interviews with industry executives and observers. The respondents argued that clearing brokerages should perform a critical self-evaluation and decide if it is time to move on-let someone else clear for them or stop clearing for others-or to prepare to make a huge investment in a clearing platform.

How should a firm approach this decision?

First, says Mirchandani, a brokerage must ask if it has the ability to clear and wants its clearing operations to survive. It must decide whether clearing is a core competency (see sidebar: “Smart Firms on Their Focus Competencies”).

“The dramatic changes that have occurred in the clearing industry have created a disadvantage for firms who try to maintain control over their own back office and an advantage for firms who focus on their core competencies,” Mirchandani said. “Firms may be better served by entering into a fully disclosed clearing relationship and focusing their resources instead on the client and adviser experience.”

And, in deciding that, Mirchandani notes, a firm should also consider other issues.

Do a clearing broker and its parent have the array of new products needed? Are the firm or its parents ready to devote the time and resources to the business? Can a firm keep up with the increased regulatory costs, and is it ready to invest millions, perhaps of tens of millions, of dollars in upgrading its platform?

Most smaller to midsize brokerages, adds a Mirchandani colleague, should farm out the clearing function. That would mean devoting less time and capital to back-office operations. It would also mean more time for front-office operations, including developing relationships with advisers and other clients. The back office, explains Stephen Langlois, National Financial’s chief administrative officer, is where brokerages are less likely to offer what clients want.

“The small and midsize firms should think seriously about the value proposition they offer to advisers. And they should think about if they can offer that in the back office,” Langlois said. Many of them, he noted, are facing shrinking profit margins as their pricey back offices drag them down.

Small and midsize brokerages must make hard decisions as to whether clearing and settling trades is really integral to their firms.

Brokerage executives told CQ&D the answers are sometimes not obvious. Some firms generate huge amounts in annual revenues and would not seem to be candidates to end clearing operations. However, even some of the biggest brokerages aren’t committed to a strong back-office effort. Other brokerages, they said, are the usual suspects for getting pushed out of the business.

“I would say firms of between 50 and 100 correspondents face a very difficult existence,” said Dannemiller of LaRoche Research. He can list dozens of brokerages in that category. These are new candidates for the Darwinian winnowing-out process that continues in the clearing business.

Dannemiller adds that, unless a client has a few correspondents that generate extraordinary business, it is almost impossible to find enough revenue to support a clearing brokerage with 100 or fewer correspondents. But he also adds that decisions about self-clearing or continuing to clear for others can touch on more than just size.

Langlois wouldn’t give a correspondent survival number because, he says, some big firms, with lots of clients, are finding clearing a tough go. He said that “all firms,” including those with the capacity to self-clear, should re-examine their position, owing to today’s environment.

“We are seeing firms with tens of billions of dollars of assets, looking to make the switch from self-clearing to fully disclosed. In that case, size doesn’t matter,” Langlois said.

How does one know that exiting the clearing business is the right decision?

“It is a qualitative decision. It is also a strategic decision,” Langlois said.

He asked, “Does [a firm] want to spend tens of millions of dollars on back-office operations or would they rather spend that money on adviser interfacing opportunities?”

Interfacing opportunities, Langlois added, mean the firm has the ability to look at and discuss all of a client’s assets at the same time as the client. This permits the firm to manage and advise on a comprehensive basis.

It is a collaborative work style that is critical in broadening a relationship and obtaining a large share of the client’s total assets. This requires an investment of tens of millions in a brokerage’s workstation, he notes.

“We have some large correspondents who do some of that. But then they usually decide that they have to partner with someone to continue doing this,” Langlois said. The workstation, he adds, should allow the firm to manage all client assets, including those outside of the firm. Most clearing firms, Langlois believes, can build this platform, but they should again seriously consider whether they want to do it. It is a strategic decision, he says. Are clearing services, Langlois asks, where and how the firm wants to specialize?

“They can do it. But it is very, very expensive,” he said. He added that the decision is often qualitative, not one based solely on revenues and number of transactions.

“Firms thinking about clearing,” Langlois said, “should ask if it is the best use of capital or not.”

Another part of passing the survival test is deciding if the firm will be able to cope with a heightened regulatory environment. The costs of complying with increased regulation have been dramatically rising for the last few years. And they will continue to rise. That’s because the Dodd-Frank Wall Street Reform and Consumer Protection Act has some 398 required rules and only about a third were recently finalized, according to Mirchandani.

When final, these rules are expected to total 29,000 pages, industry observers predict. Is every firm that wants to clear ready to cope with that? And what does that mean for clearing brokers?

It means tough times, especially for those firms that expect to clear for others or to continue to self-clear, according to Mirchandani.

“Rising technology and compliance, combined with increased competition for clearing services, have crimped margins for self-clearers, making it more difficult to support the fixed expense of a back office,” he said. Mirchandani added that many “self-clearing firms have all but exhausted their efforts to improve internal efficiency, leaving little room to cover these extra costs.”

The new rules also stipulate new capital and liquidity requirements for self-clearers. And self-clearing broker-dealers, Mirchandani notes, must be capable of meeting increased reporting and auditing requirements, as well as having more data and storage management. They must do this, he adds, “while protecting information security and privacy.”

But giving up on self-clearing or clearing for others has another side, notes Dannemiller. He says self-clearing is more than a matter of cost, although cost is a big factor. If a clearing operation is using up large resources, if it is a consistent loss leader, then the firm should examine letting an outside firm take over the function. But the decision must also include identity: Does self-clearing strengthen your relationship with a client?

“Is this a way you differentiate and maintain your brand with the client, whether it is another broker or an investor? This can be very important in how a firm keeps control of a relationship,” Dannemiller said.

Some big financial institutions have self-cleared for reasons other than saving money or brand identity, says one industry consultant who didn’t want to be quoted by name.

“They wanted to keep control of trades. They didn’t want to depend on others who might not be as careful and concerned about their clients as they are,” he said. “They wanted to keep control of their clients and not hand them over to some big clearing operation they didn’t trust.”

The clearing business, Aite’s Pirker notes, will ultimately come down to three kinds of firms.

“There will those big firms that have achieved scale, such as National Financial and Pershing,” he said. “There will be those that don’t have the scale of a big firm, but have another part of the business with lots of reps that does justify a clearing function, such as LPL Financial. And then there will be those that have neither scale in their clearing operations nor in another part of the business.

“These,” Pirker predicted, “will not survive.”


(c) 2013 Traders Magazine and SourceMedia, Inc. All Rights Reserved.