It is a familiar pattern of clearing brokerage failure: First, key clients leave. Then the number of compliance protection programs start to dry up. This is commonly followed by the inability to enter into an effective partnership with a correspondent to help the broker-dealer generate healthy growth rates.
These are the reasons so many fully disclosed clearing broker-dealers have failed over the past two decades.
So says Douglas Dannemiller. He has seen this happen time and time again as an executive inside the industry when he served at Fidelity Investments’ clearing arm and outside of it as an observer advising financial services firms. Despite the large numbers of clearing firms that have failed or had to merge, Dannemiller expects even more creative destruction looms ahead for the industry.
What clearing firms are vulnerable?
Douglas Dannemiller: Basically, firms that can’t help their correspondents organically grow will die, he warns. And that means going beyond the traditional post-trade and settlement services and becoming an essential part of the correspondent’s business. How can a firm do that? Clearing firms, he said, must help correspondents with many pre-trade functions if they are to become essential to clients. They also must be proactive in providing a service such as compliance, which is increasingly important in the wake of new rules. Dannemiller recently discussed these and other clearing issues in a Q&A with CQ&D.
The number of retail brokerages that clear for others has been on the decline since the late 1990s. What is it now?
Dannemiller: About a dozen. Around 15 years ago, that number was more than 100.
And you believe the bloodletting in the business isn’t over?
Dannemiller: Yes, I think it could drop think to about seven or eight.
What are the common warning signs that a clearing brokerage is in danger?
Dannemiller: From the outside, the warning signs can be hard to see. You need to go inside and understand their failed relationships with other firms. If sales alliances are breaking down and firms and clients are leaving a clearing brokerage, then the firm is in trouble.
Is it a problem of organic growth? Is the biggest problem that the clearing broker can’t help clients become more productive?
Dannemiller: Yes.
And so people leave and that spooks others in the business, who start shunning a clearing broker?
Dannemiller: Yes. The turnover in staff and decrease in the size of the staff. Those are warning sizes for a clearing firm. Another warning sign is the loss of key clients. The larger clients at a clearing firm move elsewhere. That’s a signal of a problem; that’s a signal that scale is being impacted.
The danger that the firm is losing control, owing to the 80/20 rule. Eighty percent of the business is recorded by 20 percent of the key clients?
Dannemiller: Yes. And when the largest clients leave, that is a sign for the remaining clients that the funding and scale for the rest of the clients are going to be further in question.
But besides the realignment issues that lead some clients to find a new clearing broker, you also believe in your experience that there is a common theme for the dissatisfied correspondent?
Dannemiller: They feel that a new clearing partner is simply a better partner for growth for them. They feel that their previous clearing broker couldn’t take them to the next stage of the firm.
So what is your general advice for clearing brokerages at a time when so many of them are disappearing?
Dannemiller: I think the main theme of those firms that are not just surviving, but prospering, is a redefinition of what is clearing. That redefinition means that successful clearing firms will transform into full-service partners with their correspondents. They will go beyond confirms, statements and market access. These firms will help their customers solve deeper business issues on critical tasks such as compliance.
Clearing brokerages should make themselves an essential part of their clients’ businesses. But how can they accomplish this?
Dannemiller: A key component of this is compliance. Compliance has become the main issue for those firms that use clearing brokerages.
It sounds as though when you are advising clearing brokerages where to put their resources in the next few years, updated compliance programs would be at the head of the list?
Dannemiller: Yes, compliance would be number one. And number two would be helping to integrate fee-based business. Essentially, what is needed is the unification of the various platforms firms have developed.
How does the clearing broker provide products that cover all the compliance needs of the client? It sounds like a difficult charge for the clearing broker?
Dannemiller: Well, the reason that is difficult is that a significant portion of the assets of the brokerage client are not executed through their main clearing service provider.
So how does one get over this contradiction? On the one hand, you want to become more important to a client. But on the other, the client is recording a lot of business elsewhere?
Dannemiller: You must provide clients with deep integration to applications that can aggregate and facilitate the compliance function. The depth of the integration of that compliance service is the key. That means integrating functions that are pre-trade functions into the compliance function along with an up-to-date picture of holdings that are both on of the clearing platform and away from the clearing platform.
What are some examples of pre-trade services that clearing brokerages should be offering?
Dannemiller: The cumbersome yet important services are suitability and the rights of accumulation for mutual fund assets.
Breakpoints are key for correspondents, but this can be a difficult task, no?
Dannemiller: Yes, to get that key discount, the total ownership picture has to be known on the client basis across all accounts. It has to be known pre-trade, and the clearing brokerage has to be able to understand all the rules around the avoidance of break points, which can be incredibly complex. You also have to be able to understand the rules around all the like assets to understand the total break point picture.
Does this mean that clearing brokerages, despite this historically not being their mission, basically have to know more and do more on pre-trade procedures?
Dannemiller: Absolutely, especially with mutual funds.
And if the clearing brokerage can’t do better on pre-trade…
Dannemiller: It will adversely impact profitability, timeliness, as well as the ability of the financial adviser to stay in the loop in terms of trade progress-as well as the ability of the oversight functions to see all of the positions and analyze them in an appropriate fashion.
Are you saying that the inability to do these things-or do them well-is another reason some clearing firms become more vulnerable?
Dannemiller: I think that one of the things that happens as you get away from the top clearing firms is the clearing services aren’t tightly integrated as part of a total offering. The tightness of that integration is critical in the clearing firm getting more business, because it is helping the client increase his business.
Why don’t firms have the ability to integrate more effectively? Is it simply because they don’t they have the resources to do it that big boys of the business do?
Dannemiller: Well, some of them don’t have the control. If the clearing firm has outsourced its core systems environment, then they don’t control the developments that are made on their core clearing platform.
But outsourcing means savings for the firms?
Dannemiller: Yes, but if you outsource your core systems, it’s difficult to keep up and satisfy your clients in a customized way.
What should firms do? Rebuild their platforms?
Dannemiller: It is very difficult to build a new core clearing platform with state-of-the-art compliance systems. It would be very difficult to achieve the critical mass; and then getting new customers puts you into “What comes first?” – the chicken-or-the-egg scenario. At what point am I going to do this, and how am I going to get there without any customers?
So we’re back to the fewer than 10 firms that will survive in the next 10 years?
Dannemiller: They will either have to have an independent platform with tons of scale, or you will have an in-house brokerage relationship that operates in a self-clearing environment.
(c) 2013 Traders Magazine and SourceMedia, Inc. All Rights Reserved.
http://www.tradersmagazine.com http://www.sourcemedia.com/
