These days, clearing is a dicey business. Problems include lean margins, firms falling by the wayside, counterparty risk, falling Federal Funds rates that hurt lending lines and big correspondents changing firms owing to numerous changes on Wall Street, among others.
Yet little of this persistent pessimism came through in a recent question-and-answer session with Penson Worldwide’s president and co-founder, Daniel Son. His firm, Son says, continues to expand in difficult times. It is already very strong in Canada (where he claims it is the largest fully disclosed clearing broker-dealer), is a player in Europe and is expanding into new parts of Asia. (It just established a presence in Australia.)
It continues to sign new clients. And Son notes that Penson is now the number three clearing firm in correspondents. Indeed, Penson’s correspondent base has increased in the last five years, from 163 to 300.
Why?
Son makes the case that clearing firms with “non-conflicted models” have an inherent advantage. By that, Son is referring to clearing firms that are primarily retail and aren’t competing with many of the clients they serve. Those kinds of firms, he argues, will prosper even in tough times if they do a few things well.
Yet it’s not all good news for Penson. It is cleaning up after a mess in Canada with client Evergreen in which no Penson official or system was at fault (see Briefs). And Penson, sensitive to the risk management issues worrying so many in the clearing and settlement field, is actually jettisoning some business. (This story originally appeared in the summer issue of Clearing Quarterly & Directory.)
CQ&D: What’s the climate for clearing firms today? Can one survive in a bear market and when volumes are down?
Son: It’s a good time for us. It’s a stressful time in the market, but we believe our model has been validated. We do execution and clearing, and we don’t compete with our customers.
CQ&D: So you have been able to expand even in difficult times?
Son: Yes, we have 24 new correspondents that have signed with us and are in the pipeline and should be generating revenue for us in the next few months.
CQ&D: However, you are also turning away some business.
Son: Yes, in the first quarter we added 17 new correspondents, and in the same quarter we terminated 19, which brought us to 300 correspondents.
CQ&D: Why get rid of business?
Son: Those leaving were generally the result of our credit and risk review, which we are going to carry out on our entire correspondent base. And that termination rate is a bit higher than normal.
CQ&D: So you’re being more particular with new business and even with clients you’ve had for years?
Son: We’ve always been particular with clients. But we are doing a continual review even with clients who have been with us for a while. To the extent that we are providing services that are not cost-efficient for us, we have raised rates for some of the services and that may have resulted in some of the correspondents going elsewhere. In other cases, we have gone through a risk review in light of what a correspondent was doing when they first came here to determine if there have been changes in their business that may affect our willingness to continue our relationship.
CQ&D: Why?
Son: We do a continual review of their risk and credit, finding out what works for us and what doesn’t. In today’s environment, the focus must intensify on risk management. As a result, our risk review may be a bit more stringent than it has been in the past. That may not be a reflection of the degradation of the correspondent’s quality, but rather an increasing of our standards. This is a risk business, and we have to be attuned to that all the time.
CQ&D: On the issue of declining interest rates, I assume that is another difficult matter for every clearing firm that has securities lending.
Son: Certainly lower interest rates have created challenges for us, as for anyone else in the stock lending business.
CQ&D: So what strategy are you using to improve your interest rate spreads in this environment?
Son: We have undertaken a proactive program to place our deposits in FDIC-insured bank accounts that provide significantly better returns. Regulation dictates the type of investments that may be made with credit balances left on deposit with a brokerage firm. We are always seeking quality and protection of funds, but we are placing blocks of money with these banks and maintaining individual sub-accounts of our customer accounts that make up these deposits. Previously, funds were invested in U.S. government-guaranteed securities, such as treasuries.
CQ&D: By rolling these accounts together and placing them as sub-accounts at FDIC-insured banks, how much better can you do on the spread?
Son: Fifty to 75 basis points.
CQ&D: That’s a significant improvement. How does it work?
Son: The baseline rate on Federal Funds is 25 basis points. By going to the banks, we’re able to get 75 to 125 on these deposits. So that’s a 50- to 75-point improvement over the Federal Funds rate.
CQ&D: How long have you been using this strategy?
Son: We initiated this program about four months ago, and we have been very careful that we have the FDIC coverage; and we look very carefully at the underlying quality of the bank. We have found about 25 banks so far that qualify.
CQ&D: You’re still looking for more banks that would qualify for these deposits.
Son: Yes, we still have potentially another $1 billion to put out for deposit.
CQ&D: Three or four years ago, I take it, you wouldn’t have looking at these banks.
Son: Three or four years ago, you did not need to think about this, because we had ways of deploying those credit balances with adequate returns to generate proper spreads. But as Federal Funds rates have declined dramatically over the past 18 to 24 months, we had to find way to maximize the returns and provide the risk management that was prudent.
