The regulators' push to clean up abuses in the brokerage industry is having an unexpected result – it is hurting the smaller brokerages, many of which are now struggling to survive. "For many smaller brokers, the challenge is to keep up with the avalanche of rules and regulations issued in the last few years," says William Alsover, Jr., chairman of Centennial Securities Company, a full-service broker dealer in Grand Rapids, Mich. "This has caused severe strains."
Regulators are responding to widespread scandals, ranging from research-related conflicts of interest, to undisclosed compensation for mutual fund sales and improper IPO allocation practices. The result is that new rules and regulations have rained down on broker dealers from Congress and federal agencies.
Last year, the NASD issued rules requiring certain supervisory controls and procedures as well as certification for chief compliance officers of those systems. (The NYSE's Rule 342 accomplished the equivalent for its member firms.) Earlier in 2004, both self-regulatory organizations mandated business continuity planning programs to ensure broker dealers have back-up plans for their mission-critical operations.
The USA Patriot Act of 2001 required new anti-money-laundering compliance programs. More recently, the SEC's books and record-keeping amendments to the 1934 Securities Exchange Act – Rule 17a-3 and Rule 17a-4 – prescribed a range of document generation and retention procedures that are difficult for some firms to manage effectively.
"The SEC and NASD have taken a very adversarial regulatory stance," says Leo Guzman, president of Guzman & Co., an institutional brokerage firm in Coral Gables, Fla. "Some of the consolidation among smaller and medium-size firms is driven by the need to comply with ever-more-stringent regulatory requirements, which at the end of the day don't make much economic sense and don't protect investors."
An example is business continuity planning for an agency brokerage operation. Guzman points out that his institutional firm must have highly reliable execution systems during the trading day. "But given the nature of our business, a full contingency plan doesn't make any sense," he insists. "We shouldn't have to have the same requirements as a Charles Schwab."
The problem for many small trading firms isn't confined to a particular set of rules. Instead, it's the escalating pile up of compliance requirements. "When I started the firm in the late 1980s, regulation seemed aimed at determining whether you were conducting an honest business under the rules," Guzman says. "Now regulation is a book of a thousand gotchas."
Barriers to Entry
Another trading executive concurs. "The business is becoming more regulatory-based. [This presents] new barriers to entry that will discourage people from entering the industry or will force people to change their models," says Robert Robotti, chief executive of Robotti & Co., an agency brokerage in New York. Nonetheless, Robotti views regulatory compliance as the cost of doing business. Institutional brokerages, trading and market making operations, as well as small retail-focused brokers, are in a period of consolidation. The larger trading and research firms must distinguish themselves in order to compete with full-service wirehouses.
The vast majority of NASD's members are small, defined as broker dealers with 150 salespeople or less. Alsover, who chairs the NASD's small-firm advisory board, notes that 80 percent of the regulator's members have 50 or fewer reps, and 50 percent of the total have 10 or fewer reps.
Under pressure from every direction, brokers have seen their ranks decline. In 2001, the NASD had about 5,500 registered broker dealer members. At the end of 2004, the number dropped below 5,200. Some firms probably shouldn't be signing long-term leases.
'Now regulation is a book of a thousand gotchas'
Leo Guzman, Guzman & Co.
"At smaller firms, we throw dimes around like manhole covers," Alsover says. For a large broker, forking over an additional $30 per rep per month for e-mail retention may not be a hardship. But for a small firm with 30 reps, that's a $1,000 cost that previously didn't exist. Alsover notes that down the line a firm may save money in time, arbitrations and regulatory actions, but the initial outlay for smaller firms is often steep. "Smaller broker dealers with a couple of analysts covering a handful of stocks will probably disappear," says Matt Bienfang, a senior analyst at research firm TowerGroup. Guzman & Co.'s president notes that the costs of compliance "are borne disproportionately by smaller firms because regulation has a large fixed-cost component." Another aspect of the burden facing small firms is that the solutions to supervisory and compliance requirements have become much more electronic and technology-oriented, according to Bienfang. "Regulatory and supervisory obligations make no distinction between large and small firms," he says. "As a result, a larger firm will likely be better positioned from an IT perspective to respond to new and existing obligations." But what about the smaller firms not well positioned from this IT perspective? Both NASD and the Securities Industry Association aim to represent the smaller broker dealer in the SEC's rule-making process. Alsover notes that the NASD has built worksheets, checklists and templates to help firms develop business continuity planning and anti-money laundering programs. The SIA focuses on other pressing issues as they arise. Last year, for example, the SIA arranged a series of weekly conference calls to help member firms cope with the retooled mutual fund breakpoint process. Clearing firms are also helping their introducing broker clients with more cost-effective services. "We're seeing some regional firms move to or considering a fully-disclosed relationship with their clearing firm. The clearing firm then provides them with backoffice support and other capabilities," says Rob Gannon, director of management services at the SIA. Technology providers and consultants also offer new regulatory compliance services. But some problems have no solution, or are outrageously expensive. For example, smaller firms have been saving and storing e-mail traffic, as required by new SEC rules, but retaining instant messages has proven to be costly. Meanwhile, execution-only broker dealers, as well as market makers, face additional critical challenges. Trading operations have become more technologically demanding. The result is that IT trading costs have risen, squeezing profit margins. This comes on the heels of decimalization, which had already compressed margins. "The margin a broker dealer makes on a day-to-day [trading] operation will continue to diminish unless there's underwriting or some other activity there," says Jay Bennett, managing director at Greenwich Associates, a research and consulting firm. Indeed, smaller full-service investment banks are finding they must specialize in order to compete with the larger players on Wall Street. "They must find sectors where there's enough underwriting as well as trading volume in the stocks to keep the operation profitable," Bennett says. Successful mid-sized brokerages with underwriting services often have a regional focus, or a specific industry focus. Bennett adds that a regional orientation drives them toward coverage of small-cap and mid-cap stocks, in part because those stocks tend to be less well followed by the research divisions of the larger investment banks. If these institutions now disappear, they will be sorely missed, according to the head trader at a Southeastern broker dealer. "They're very important to the bottom half of the Nasdaq list," he says. "Those companies need the smaller regional investment banks to raise capital and the smaller brokerage firms to be market makers in their stocks."
'Smaller firms are in touch with their local communities.'
Rob Gannon, SIA
SIA's Gannon agrees. "The smaller broker dealers are involved in the capital formation process at a local level, filling a niche the larger firms may not feel is as profitable," he says. Currently, there are officially some 300 market making firms in Nasdaq stocks. Many are barely active in stock dealing. Nevertheless, market makers now cover more stocks on average that a few years ago, says a Nasdaq spokesperson. For some firms, this shift in market making activity is an opportunity. Guzman & Co., for example, launched a new market making and research operation last fall. He recruited the well-known trading veteran Arthur Pacheco. The firm had built a reputation in program trading and index-related trading and research. But with the number of market makers specializing in smaller stocks decreasing, Guzman decided to branch out. Target Market The firm's target market for its new market making activity is the bottom 500 stocks in the Russell 2000 index – companies with a market cap of $400 million or less. "It's a very underserved market in terms of market makers and research," Guzman says. But firms that specialize can still be overshadowed by the big guns. "If Goldman or Morgan Stanley or Merrill Lynch chooses not to cover a company and then the company decides to spin off an operation or wants to do a secondary offering, it hasn't been proven that they won't be invited back in," Greenwich's Bennett says. "That will ultimately determine whether the economics of the remaining broker dealers who cover the company will be positive, neutral or negative." Although most would typically be included as a co-lead on a deal, Bennett adds that smaller firms still struggle to compete with the stronger distribution and balance sheets of larger firms. Then there is the buyside. "Unless you're offering top-notch research that's consistently of value to the buyside, or you have major capital commitment capabilities, it's becoming harder for small brokerages to do business with the buyside today," says TowerGroup's Bienfang. Placing all of a firm's eggs in one sector is also risky. For example, when the tech market tanked in 2000 and research demand subsided, Pacific Crest of Portland, Ore., felt the heat. Larger firms dropped coverage of a lot of tech issues, but Pacific Crest soldiered on. "It's a double-edged sword," says Roger Levine, managing director in charge of trading, "but we became more important to some of our customers." He adds that his firm doesn't pursue order flow by offering a rock-bottom commission rate. "We have a premium product that deserves a premium price," Levine says. "It's been a good model for us." However, one area where smaller firms simply can't compete with their larger brethren is in capital commitment. Pacific Crest's Levine notes that he often makes a one-million-share market in Microsoft, but that the larger Wall Street brokers – with their massive capital resources – can "do that all the time."
'The industry would be better served by less paperwork.'
John Adams Vaccaro, SIA Small Firms Committee
Like many survivors, Robotti &: Co. has also carved out a niche for itself. Most boutique broker dealers focus on growth-oriented stocks. Robotti provides value-oriented research in the micro-cap, small-cap and mid-cap sectors. The firm runs a brokerage operation and an asset management business. "We issue research, make markets, and trade in those securities daily," Robotti says. "We also eat our own cooking on the asset management side." Like institutional brokers and market makers, retail brokerages are also coping with lower profit margins. Many have become dual-registered as broker dealers and investment advisers. Rising compliance and administrative costs have also compelled some to jump ship entirely and head into the fee-based advisory business. Andrew Klein, a partner at law firm Schiff Hardin, thinks this is part of a broader consolidation trend and shouldn't be chalked up to a heavy burden of compliance requirements. "Increased diligence by the NASD or NYSE, or the SEC's insistence on more complex compliance systems – and I have no doubt that that insistence is larger these days – may be a factor," Klein says. "But you really have to ask," he adds, "what function are these little retail firms performing that can't be performed cheaper by a large outfit?" Still, retail brokerages may have a role to play. SIA's Gannon points out that the "chief advantage of smaller [retail] firms is that they're in touch with their local communities and can provide hands-on service." Klein acknowledges a role for smaller broker dealers, albeit a slim one. Beginning investors, who don't have stores of money, want personal service. "That's a role for the small broker dealer/investment adviser," Klein admits. Some brokers remain optimistic. Retail and smaller institutional brokerages may find new opportunities in the changing investment landscape, says John Adams Vaccaro, CEO of Westport Resources Investment Services, a broker dealer that has an affiliated investment advisory firm. Vaccaro, who heads the SIA's small firms committee, notes that wirehouses have been cutting face-to-face services for smaller clients, relegating them to call centers. "But these smaller clients might have several hundred thousand dollars in assets and have real needs," Vaccaro says. Entrepreneurial smaller firms can fill the space. However, that brings us back to more rules and regulations. Vaccaro believes the brokerage community would be better served by less paperwork. It's not unusual, he notes, for an NASD examination of a broker dealer to be followed by an SEC exam as well as a state exam. Vaccaro says the small guy might get a break if government regulators and SROs would stop tripping over each other.
