It just can’t get any worse. Falling broker-dealers that couldn’t hack it, firms that died or were swallowed. Margin business ruined by uncommonly low interest rates. And those rates guaranteed by the Federal Reserve to stay dirt cheap for at least for another year. Transaction volume-the mother’s milk of the clearing business-is lagging.
Numerous clearing broker executives and industry observers have pointed to all of this over the past few years, as the business has slumped.
"It’s a business built on volume. But volume has been down for the past three years," said Sang Lee, a clearing industry analyst with Aite Group. "And there is no immediate prospect of volume going up."
"Times seem to be at their worst," concurred Craig Gordon, a longtime clearing veteran with RBC.
But maybe not.
Some industry observers say there are at least two hopeful factors in the near term-besides the obvious one, a potential volume comeback. These two factors would provide a rosy scenario for both parts of the clearing industry, the institutional business and retail.
For institutional clearing, the hope is the renewed promise of over-the-counter derivatives, a type of business that, prior to this, has infrequently gone through clearing.
But regulators are now pushing this kind of business-business in the trillions of dollars-the clearing industry’s way. The Bank for International Settlements says the notional value of all of it is in excess of $700 trillion.
The clearing of OTC derivatives also represents a fabulous new source of potential revenues. Until recently, the clearing industry largely has been bypassed. But now, thanks to U.S. lawmakers, it could receive a huge amount of the business. It is so big because these contracts, which include credit default and interest rate swaps, are very popular with big businesses that need to hedge risk.
Indeed, 94 percent of the world’s 500 largest companies use derivatives to manage their risk, according to the International Swaps and Derivatives Association.
Many of these transactions, which were once done privately, will be going though dealers with clearing arms, clearinghouses and CCPs for the first time over the next few years. That’s owing to the Dodd-Frank Act, the financial reform law of 2010.
The law projects clearing as a way to prevent a repeat of the OTC derivatives market meltdown of 2008. And that also means institutional clearing operations are gearing up to get a bigger chunk of this huge market, which is expected to grow faster once new rules are in force, designed to reassure investors that these contracts will be effectively regulated.
The caveat is that regulators are in a marathon process of writing rules for clearing platforms that will handle this business. Clearing firms will have to prepare now for these rules, even though many of them have not been written.
"We’re going to have guess at some of these rules now, such as collateral and margin requirements, or we could be at a sudden competitive disadvantage," said one executive at a swaps dealer with an OTC clearing arm who wouldn’t be quoted by name.
These rules will require exhaustive risk management controls and huge amounts of collateral for those who expect to be big players.
"Only the biggest players are going to be able to effectively compete," said Will Rhode, a principal with industry consultant Tabb Group. "You will need to provide risk management and many other services to be able to obtain this business."
The other hopeful factor for the clearing industry is in the retail space. For those offering retail services, there is the promise of the registered investment adviser. This is an expanding segment that is playing off the continuing fragmentation of the securities business.
Many financial professionals are leaving big national firms. They are starting their own RIA businesses as technology makes it easier, catering to fee-only or fee-and-commission clients. And already these advisers are acting as financial intermediaries for a huge amount of assets, said Tyler Cloherty, a senior analyst with Cerulli Associates.
"We are expecting vigorous growth in the RIA business in the next few years, as more and more financial professionals go out on their own," Cloherty said. "This is a trend that we have been seeing for some years and we expect it to continue for some time."
Why are these numbers important for clearing broker-dealers?
These former employees of national firms and now new entrepreneurs will need a wealth of support services. Among those services will be the full range of clearing and other post-trade services.
"The RIA firm is a business that will really need what clearing firms with a wealth of services can offer," said Doug Dannemiller, a clearing analyst with his own research firm, LaRoche Research Partners. They’ll want much more than just traditional clearing and settlement, Dannemiller says.
These advisers, he adds, will be looking for clearing platforms that can provide data integration and help them with the considerable regulatory reporting requirements that come with separate managed accounts. Dannemiller points to Pershing’s Adviser Solutions as one such effort to attract this booming business.
These advisers are expected to intermediate about a quarter of the total retail assets, or some $2 trillion by the year 2014, Cerulli says.
"And they will need to interface with a number of platforms, including those that provide clearing," Cloherty noted.
Who will be the most successful players?
As with the clearing of OTC derivatives, observers agree a firm will have to invest hundreds of millions of dollars in a platform.
"If you’re trying to compete by just starting a platform now, you’re already too late," said Cloherty.
Who is ahead at this point?
Cloherty says Charles Schwab & Co., Fidelity Investments and Pershing are among the big players and have made huge investments preparing for the coming RIA boom.
But there is no doubt that these firms and others are attracting more and more assets, he says.
Indeed, these numbers are already showing up in assets under management. Last year, the total amount of RIA assets under management, including retail and institutional business, was up by some 14 percent, according to National Regulatory Services and the Investment Adviser Association.
But the biggest opportunity for the clearing industry may be the clearing of OTC derivatives. What’s exciting about that is this business is almost untouched, according to a recent Tabb Group report, which surveyed the views of institutional clients on clearing.
"Buyside clearing is near nonexistent now, but the process has begun with nearly a third of respondents, mainly hedge funds, conducting test trades. Big dealers with clearing divisions are lining up to take a piece of this business," according to the report (see sidebar, "Which Dealer Will Do the Best in the New OTC Clearing World?").
On the clearinghouse side, the same Tabb survey shows that the majority of firms interested in OTC derivatives business already have made decisions on where to clear swaps. They favor clearinghouses such as CME, LCH and ICE.
What will make a clearinghouse successful?
Several factors, says an industry analyst.
"When picking a central clearinghouse, the primary factor is cost," said Tabb Group’s Rhode. Other factors include a CCP’s track record/relationship, operational risk and asset protection.
These are factors that will also affect the continued growth of the RIA business and where it goes to obtain clearing business. All these factors, RBC’s Gordon hopes, will be part of a clearing industry turnaround.
Gordon describes himself as a contrarian. "I think that five years from now, we will be looking back and saying that this was the beginning of a great period when RIA business really picked up."
Sidebar: Which Dealer Will Do the Best in the New OTC Clearing World?
Some dealers are already way ahead in preparing to obtain a big slice of the new over-the-counter clearing derivatives market. In fact, one brokerage executive privately told CQ&D that, "if you haven’t already built operations for this kind of business, it’s too late now because a lot of firms are ahead of you."
Indeed, J.P. Morgan, Barclays, Deutsche Bank, Goldman Sachs and UBS are already ahead in the race to capture a big slice of the business, according to industry consultant Tabb Group (see chart).
"The firm that seems to be getting it right is J.P. Morgan," says a Tabb Group study. "J.P. Morgan was almost twice as likely to be mentioned by the firms we interviewed as offering the most robust platform for cleared OTC swaps, with 57 percent of funds mentioning them."
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