Robert Mumby, who runs Baltimore-based RM Associates, which advises clearing brokerages, has seen many firms in the industry fail. Mumby, who has had stints with J.P. Morgan/Bear Stearns, Alex. Brown & Sons and Cowen & Company clearing operations, is a veteran of the clearing business of more than 30 years. He has seen the number of clearing brokerages dramatically decline over the last 15 years, going from 125 about a decade ago to fewer than 20 today.
Why is this business so Darwinian?
Many clearing brokerages have not been able to remake themselves, Mumby explains.
Today, they are expected to do much more than just clear and settle, he says, and if they don’t offer a bevy of new services correspondents will go-and have gone-to third-party providers.
The clearing broker’s legal responsibility for clients, Mumby adds, is increasing, as detailed in the decisions against Goldman Sachs in the Bayou case. In the case, arbitrators and courts have repeatedly held that the brokerage is responsible for the problems of the introducing broker clients (see CQ&D, Winter 2011). This comes at time when trading volumes are much lower than five or six years ago and the central bank’s promise of continued cheap money means margin business produces very little revenue, according to industry observers. Add industry consolidations and poor business conditions to these difficulties, and it should come as no surprise so many firms have gone away.
But Mumby says the current problems in the business are not unusual. He says the latest wave of clearing brokerage shakeouts are part of a series going back to the 1980s. In a Q&A with CQ&D, he addressed some of these challenges and discussed the recent history of the clearing business. He also explained how and which clearing firms will survive and even prosper.
CQ&D: You’ve seen clearing brokerage shakeouts before. Let’s begin at the outset of your career. What was going wrong for clearing brokerages then?
Mumby: It was primarily a transaction-based and execution revenue model. Financing was growing as margin debits grew through the ’80s because of the market surge that began in 1982.
CQ&D: And so there weren’t nearly the demands on the clearing firms.
Mumby: Yes, they really just processed the business. And there weren’t really as many demands on the introducing brokers. There was also a very clear delineation regarding the business from a legal and regulatory standpoint.
CQ&D: The business wasn’t as difficult?
Mumby: Yes, you could know your customer supervision delineation was clear and everything was in the hands of your introducing broker.
CQ&D: As detailed in Rule 382 of the New York Stock Exchange?
Mumby: Yes, the client and the business being done was the responsibility of the introducing firm. The clearing firm was just a processor.
CQ&D: Now, looking at the Bayou decision, everything has changed for clearing firm in its client responsibilities?
Mumby: Yes, that is huge.
CQ&D: How?
Mumby: If that burden is officially shifted to custodian and clearing firms, it will utterly transform the business.
CQ&D: But isn’t that shift taking place now?
Mumby: Yes, it’s already a huge burden to be a clearing firm in many ways.
CQ&D: How has this developed?
Mumby: There were cases going back to the 1990s that have forced clearing firms to be more involved in what they’re processing, how they’re processing and why they’re processing. They have had to give tools to introducing firms, helping them to manage supervision and know their sales practices and on and on.
CQ&D: An example of that?
Mumby: It began with some of the complications Bear Stearns had with some of their clients back in the late ’90s. The first wave of that were industry rules that required clearing firms to send a list of compliance reports to each introducing broker. And secondly, the requirement that any customer complaint that comes to a clearing firm regarding an introducing firm must be forwarded to the SRO.
CQ&D: But client attorneys have pointed to clearing firm officials that have closed eyes to the dishonest practices of clients, but went along and processed their business…
Mumby: Naturally, clearing firms have done some things wrong. But if the result of all this is the clearing firm has the ultimate responsibility for the introducing broker, then it will have a dampening effect on the individual investor.
CQ&D: And so?
Mumby: Their opportunities to go to a small or middle-size clearing broker will be impinged because the clearing firm’s cost of business in risk and protection will be transferred to the introducing firms.
CQ&D: So it comes down to today, the industry is down to fewer than 20 clearers.
Mumby: Depending on how you classify it, it’s actually somewhere between eight and 15.
CQ&D: How do you advise these clearing survivors to make money? It seems to be an impossible business.
Mumby: No, not really. With changes like these will come opportunities, and the industry adapts.
CQ&D: Challenges, but opportunities to make changes-that’s what you have said about the clearing industry. Please explain.
Mumby: For instance, I believe traditional pricing of clearing and custodian services needs to be looked at. Charging on a transaction basis isn’t going to cut it anymore.
CQ&D: Why?
Mumby: That doesn’t accurately reflect the other costs and values and risks of providing valuable services.
CQ&D: Some trades are much more daunting than others?
Mumby: Right. And also there are other factors that must enter into pricing. They are fixed costs of being able to provide clearing: the firm’s balance sheet, technology and subject matter expertise; the firm’s breath of capabilities across assets and borders. These all must enter into pricing.
CQ&D: So some firms have not be able to properly adjust their pricing. And some, you have said, are not able to provide all the expanded services clients today demand?
Mumby: Yes, the breadth of demands beyond just being a processing platform.
CQ&D: Some examples of these expanded demands?
Mumby: Well, brokerages face demands for an Internet front end for both account access and for trades. With the demands on brokerages for online trading came the demand for clearing firms to support that.
CQ&D: And also…
Mumby: The product and reporting demands of clearing firms for fee-based accounts and managed accounts, as well as retirement accounts.
CQ&D: That overwhelmed some clearing firms in the 1990s and early 2000s, right?
Mumby: Yes, firms have been forced to add a singular amount of overhead and bodies. And I believe they added the bodies and capacity without re-engineering their businesses.
CQ&D: They made a mistake. They thought high volume would ensure their survival?
Mumby: They thought they wouldn’t re-engineer, but just take in the additional business and do what they had to do to keep up, because the revenue opportunity was too great.
CQ&D: These high-volume times were the halcyon days?
Mumby: Yes, a huge growth in volume and ticket volumes, and online trading at least doubled.
CQ&D: But some of the clearing firms that have failed, you have argued, ultimately let clients develop relationships with others who provided services the clearing firm couldn’t.
Mumby: An example of this was trading systems. The clearing firms stopped trying to provide trading and inventory systems to their introducing firms because the clearing firms were just too busy keeping up with the volumes.
CQ&D: Another area where some clearing firms haven’t kept up?
Mumby: Fee-based and managed accounts. A lot of firms started to going to use third parties, like a Brinker or a Lockwood.
CQ&D: Little by little, firms lost lines of business?
Mumby: Things like new account opening, compliance, commission tacking. All these ancillary processes led introducing brokerages to spend a lot of time not with their clearing broker, but with third-party providers, because they were things the clearing firms weren’t inclined to handle.
CQ&D: But a few clearing brokerages, among the survivors, didn’t just take the extra business, they did re-engineer.
Mumby: Yes.
CQ&D: But you contend that in the market meltdown in 2007-2008, we faced the latest wave of clearing brokerage shakeouts. Part of it, you believe, is a brutal price competition among clearing firms that has been going on for more than a decade.
Mumby: It was a decimating price competition for this industry, and it was exacerbated in 2008. And clearing firms, wanting the revenue, would do whatever they had to do to keep the business. So we have had a ridiculous 10 years of price competition.
CQ&D: There has to be a repricing for clearing brokerages to do well?
Mumby: Yes, to reflect the demand, the costs and the risks upon a clearing platform.
CQ&D: How?
Mumby: I don’t know exactly. But prices will be more based on custody and asset protection; they will be based the implicit and explicit capabilities of the introducing firm. And that can be based on global capabilities or multi-asset capabilities.
CQ&D: But those days are gone. What happens now? How will firms that survive reinvent themselves? How will they get back the introducing firms, which have sent so much business to third-party providers?
Mumby: The introducing firms had to go elsewhere for custody, compliance and account opening and so many other things over the past 15 years. Clearing firms now have a re-outsourcing of these functions.
CQ&D: Re-outsourcing? How?
Mumby: If you look at the major independent brokerages, they have now a huge amount of data aggregation. For instance, right now they’re holding data at the funds they have and at the variable annuity manufacturers. They are spending a lot of money on their own to do this stuff in-house, either on their own or with third parties.
CQ&D: So you’re saying the clearing firm that could do a lot of data warehousing, relieve these brokerages of a lot of their current burdens, could pick up a lot of business?
Mumby: Right.
CQ&D: So say I’m a brokerage and I hold half my data with one firm and half with another. A clearing brokerage should target this client?
Mumby: Yes, it’s a natural competition between the utilities and clearing firms, between clearing firms or between clearing firms and third-party processors.
CQ&D: Ultimately, you believe the successful clearing firm will be able to use information and the value of a clearing platform to survive and prosper?
Mumby: I think it is going to be an adaptation of clearing firms with their existing clients based upon the value the clearing firm is providing.
CQ&D: So you’re not talking about the firm taking away customers from other firms or waiting for the next great wave of volume to lift it. You’re taking about firms prospering with existing clients-not with more transactions, but by improving existing relationships?
Mumby: Yes, for instance: What value is the clearing firm providing the introducing firm?
CQ&D: How will this value idea be sold to the client? On what basis?
Mumby: The balance sheet of the clearing firm, the reputation of the clearing firm, the breadth of the clearing firm as far as its cross-border capability and its multi-asset capability.
CQ&D: Firms that survive in a Darwinian environment will sell value, which will include reputation and balance sheet values?
Mumby: Yes, some clients are going to say, “Am I going to be going to the next clearing brokerage that will die, or am I finally going to a place I know has some staying power? Maybe I should pay up for it.”
(c) 2012 Traders Magazine and SourceMedia, Inc. All Rights Reserved.
http://www.tradersmagazine.com http://www.sourcemedia.com/
