Many financial firms find it efficient these days to outsource trade clearing functions at the same time that there are fewer competitors in this difficult business. And continued consolidation is inevitable, several players say.
"In the mid-1990s, there were probably 135 correspondent clearing groups," says Norm Malo, president of National Financial, the correspondent clearing arm for Fidelity Investments. "Today there are less than 75. In five years, there may be less than 50."
This is happening when demand for these clearing services is on the rise. Most financial firms have now opted to hire correspondent clearing firms. There are roughly 350 firms left in the U.S. clearing for themselves, according to Matthew Bienfang, a senior analyst with TowerGroup.
"I see a final changeover from the self-clearing model, that broker dealers insisted on some years ago, to this new model in which firms outsource as much of their securities operations as possible," Malo says.
Correspondent clearing customers now want these firms to hook them up with front-end order management systems, and have the rest done for them as seamlessly as possible. The idea is to save money by substituting high fixed-costs for the variable models provided by clearing firms.
This intensified move to outsourcing has been paralleled by the changes in ownership of correspondent clearing firms. Bigger firms are now players in the business. Among the notable deals of recent times: Pershing's acquisition by Bank of New York (now regarded as the largest securities processor in the world), and National Financial's purchase of Correspondent Services Corporation.
This consolidation is driven by technological advances. "Automation has allowed a few big players to clean up because they can afford to cost-effectively connect to securities depositories and to the central bank payment systems," says James Coulter, a partner of Reference Intelligence, a small New York-based consulting firm. Nevertheless, the bigger players are usually careful about their purchases.
"When a big firm buys a smaller firm, there is a pretty careful focus on what kind of customers a new acquisition can bring," TowerGroup's Bienfang says. The Pershing acquisition is a good example. That's because the Bank of New York simply did not have the same expertise in the equity business that Pershing had, an expertise the firm has been honing ever since 1939 when it was established, Bienfang adds.
Fishing Business
Little fish will also eat other little fish. "I think you'll also see a lot of little firms merging their operations," Bienfang says. "Some of the little fish know their niche; they are meeting their clients' expectations; their business model is working, so while they need more scale, they don't want to sell."
But some firms will simply drop out because of constant technology costs and the downward pressure on pricing. However, rising volumes in the last 10 years, and expectations of big volume coming from Asia, particularly China, is changing the outlook. There could be more opportunities for success for those willing and able, despite the ever downward price pressures.
"Price is always an issue, but philosophically, we have decided that we're not going to be the cheapest deal on the street, but we'll offer the best service instead," says Daniel Son. Nine years ago, he and Phil Pendergraft founded Penson Financial Services in Dallas with nine employees and a handful of customers. Penson now has offices in three countries, 900 employees, and processes tens of thousands of transactions a day.
The key to survival in correspondent clearing is service, explains a Pershing official. With it,
scale can be earned. "Although our group clears for 1,100 broker dealers, we wrap each of our clients in a cocoon of service people, organized in dedicated relationship teams," says Michael Row, a managing director in Pershing's National Customers Group. These teams can provide everything from day-to-day service on any product their customers offer, to training and Website development and enhancement. Service, in fact, is how correspondent clearing firms that are not giants, differentiate themselves.
Another survival technique is to specialize in serving specific types of customers. "We don't currently clear for any mutual funds," says Penson's Son. "We look for other types of customers."
One client that correspondents seek is a very active retail trader like CyberTrader. After they were bought by Charles Schwab, Penson continued to clear for CyberTrader which has some 25,000 accounts that generate 50,000 to 60,000 trades a day.
The ratio of trades to accounts in brokerage firms with traditional accounts is much different. Schwab, for example, has some eight million customers who record about 200,000 trades a day. Smaller traditional brokerage firms have the same ratio of total customers to daily trades.
Banks now offer great opportunities, National Financial's Malo says. "All of a sudden, banks have multiple segments high-net-worth, ultra high-net-worth, and trust departments," he adds. "Banks are no longer a one segment market of brokerage arms they have acquired."
Another new type of customer is the black box investment manager who uses computer programs that can sometimes automatically generate as much as 10,000 trades a day. This customer type is very keen on straight-through processing (STP), as are ECNs which are another type. There are also small firms with 20 to 50 employees serving hyper-traders (aka day traders) which, like black box traders and ECNs, need services as close to STP as correspondent clearing firms can get.
The Professionals
Then there are listed traders, professionals and semi-pros, who trade on the NYSE DOT system. Finally, there are insurance broker dealers who need a lot of ancillary services, but do less volume.
Firms that are not goliaths tend to concentrate on particular types of business. An example of this is Spear, Leeds & Kellogg, which is institutionally oriented, and does not court retail. Most customer segments depend on super-fast front-end execution systems they can plug into without being forced to conform to their clearing firms' systems. Many want to white label' their clearers' systems so that end-users can seamlessly access what they need on their own brokers' Websites.
Clearers report that all of their customers are asking for immediate access to trading activity to satisfy regulators.
"Demands by regulators for reports seem to be almost a daily event these days," National Financial's Malo says. In short, customers want it all, just as they always have. "Technology is a major factor in our business, but customers want to use their own protocols," Penson's Son adds. "They want good product capabilities, but they also want great pricing."
What is clear is that correspondent clearing, despite all the consolidation, is not exactly the commoditized business many casual observers once considered it. Sure, electronic processing is a little like electrical screwdrivers in many ways they are all pretty much alike. However, the key to success for correspondent clearers lies in how deftly and efficiently they can use their own industry tools, observers note.
"Our strategy today, listening carefully to customers and continuing to innovate for them, is no different than it probably ever has been," says Row at Pershing. "You're never done, and you will never have the perfect model that will work forever."
