If you haven’t noticed, the number of firms offering clearing services is dwindling. During the last year alone, Weiss, Peck & Greer sold its correspondent clearing business to BNY Clearing Services; Fiserv Inc. took over Investec Ernst & Company’s correspondent clearing concern; Deutsche Bank Alex. Brown folded its clearing tent, and it’s been reported that Credit Suisse First Boston (CSFB) is shopping Pershing. Why are firms exiting the business? They can’t afford to stay in. And what does this shrinking pool of clearing providers mean for advisors? Probably something good. The survivors, contends Pershing CEO Alton Jones, “will have a more robust menu of products and a higher quality of service for [advisors] to use for their business and to extend to their clients.”
Indeed, with trading volumes lagging, some firms simply lack the wherewithal to maintain expensive technology platforms, pay personnel, and provide adequate products and service levels. Many brokerage firms “built up their [clearing] business substantially to accommodate the trade levels in 1999 and 2000, and invested a lot in equipment and people,” says Bob Beriault, president of Fiserv Securities and Trust Processing Group in Denver. “Then, in 2001 and 2002, we saw large [trading] declines,” which resulted in operating losses for some firms. “Firms were hoping trade activity levels would pick back up and help them with their lack of profitability because the [clearing] model is built to support a lot of trade activity, margin debts and associated revenue.” But because the clearing business is largely driven by fixed costs, he says, “A lot of revenue needs to flow through the pipe to make it profitable.”
Jones adds that it’s not only sluggish trades that are to blame for firms fleeing the clearing scene. Reduced margins in market-making are taking a toll as well. “Margins have been substantially reduced for[companies] that are doing [clearing] as an add-on, not as a core business,” he says. So for those firms, “the cost of doing the business–whether in people, technology, or capital usage–no longer makes economic sense.” Meanwhile, constraints on capital can compromise a firm’s ability to satisfy customers’ appetite for more products and better service. The bottom line is that customers, whether consumers or broker/dealers, “aren’t going to pay for what seems to be perceived as a commodity, and that’s clearance,” Jones says. “If you’re not a major player, you don’t have the volume and economies of scale to move with the commoditization of prices, and at the same time have the capital and other resources to provide the additional products and service.”
Indeed, poorly capitalized firms will continue to get squeezed out of the market because they can’t develop the cutting edge front-end technology that their retail brokers need, Beriault says. Besides providing new products and great service, “You have to be able to put on your retail [broker/dealer's] desktop the same types of technology that a Merrill Lynch broker is going to get.”
Beriault says Investec Ernst is one example of a firm that could no longer afford to keep pace with technology spending. Firms that provide clearing for their retail broker/dealer force–like Bear Stearns, Pershing, and U.S. Clearing–he says, have weathered the dropoff in trades better than those firms that didn’t have a retail order flow to support. Firms supporting a B/D force can create “excess capacity by providing their technology platforms and clearing services to small- to medium-size broker/dealers who can’t afford to do the [clearing] structure themselves,” he says.
Investec Ernst’s clearing business, on the other hand, had become less lucrative because it “outsourced its own retail [broker/dealer] division, and was left clearing for third parties and its own trading platforms.” By acquiring Investec Ernst last August, Fiserv is now able to “get more revenue on our platform, and to keep on spreading our development costs for technology add-ons to our retail customers,” Beriault says.
Clearing Is a Tall Order
Ron Suber, managing director of global clearing at Bear Stearns, says it’s also imperative that clearing firms “have open, flexible technology,” and reporting solutions so that correspondent broker/dealer clients can comply with regulations like best execution and order audit trail systems (OATS), the audit trail of order, quote, and trade information for Nasdaq securities.
This is a tall order. In fact, Bear Stearns’ Suber says firms often turn tail when they realize that “clearing for introducing [independent] brokers is much harder than it appears.” When faced with the task’s complexities–and expense–and the realization that “it’s a true long-term commitment, they often reverse course and sell off their clearing entity.”
Even though Pershing, which is the nation’s second-largest clearing firm, has been able to generate healthy earnings in a bear market, its parent, Credit Suisse First Boston, is said to be looking to sell the clearing arm. Jones declined to discuss the reports, but according to The Wall Street Journal, CSFB has faced significant losses of its own and would rather continue investing in more core operations like securities lending and underwriting. Bear Stearns, Fidelity Investments and BNY Clearing–all major players in the clearing business–are reported to be prospective buyers.
Want to Survive? Offer Best of Breed
The larger, more robust firms like Pershing that do survive a consolidation binge, Jones says, will be able to deliver the crucial products advisors are looking for like best of breed mutual funds, hedge funds, and leverage funds. Products for high-net-worth clients such as real estate and equity limited partnerships, collars, and alternative investments are also becoming mainstays of advisors’ diets. “Providing those products on a platform that’s integrated for execution, processing and clearing takes a tremendous amount of resource and size,” Jones says. Regional clearing firms and those firms that just clear their own trades, he says, are less likely to provide a wide menu of products.
When it comes to service, those firms that clear trades for a living have the capital to process them on a straight-through basis. This means “empowering the financial representative and his customer to pull down information that they want or push back info that they need to give to the B/D they are affiliated with or straight through to the clearing organization,” Jones says.
Pershing, like some other firms, has reengineered its technology to allow for a quicker, more seamless interaction between broker and the clearing firm. A Pershing broker or her client can now “pull down research, credit advice, see the status of transfers,” and have an interactive dialogue, Jones says. This, of course, eliminates physical handling of forms, and e-mail and voice-mail tag, and provides an immediate response. Putting such an infrastructure in place while supporting their core business is becoming too expensive for “the smaller players and/or regional [clearing firms],” Jones believes.
But well-capitalized firms like Pershing, Fiserv, and Fidelity Investments’ correspondent clearing business, are plowing more cash into their clearing businesses these days. Fidelity invests $2 billion in technology annually, says Peter Benzie, executive vice president of Fidelity’s Correspondent Clearing Unit. “My budget [for the clearing business] has grown substantially,” he says. Beriault’s division at Fiserv brings in about $250 million in annual revenues, and 10% is devoted to new technology. In 2002, Pershing devoted $300 million to technology investments, both domestic and international.
Unlike most other clearing firms, Fidelity’s clearing division is booming. Trade volume is rising, and “from a sales point of view,” Benzie says, “this will be our second best year ever,” based on the number of new institutions Fidelity has added. The clearing arm’s business with existing clients is also faring well, as are expenses, which were expected to be lower than projected at year-end, he says.
How does Benzie account for the increase in trades? “We try to develop business with our existing customer base,” he says. “One account had a separate business that we were growing in the high-net-worth area, and we were able to transfer those accounts in, and that actually increases our assets and trades per day.” As for product penetration, Fidelity figures out ways to penetrate its existing customers “with more of our products to help them achieve their goals.” Fidelity has also added more accounts this year. “As you convert those accounts onto [Fidelity's] platform, it increases our assets, number of accounts, and trades per day.”
The Broker/Dealer Shift
Benzie says a number of trends are changing the relationship between clearing firms and broker/dealers, which is making clearing an attractive business. Clearing providers now have the opportunity to have a fuller relationship with brokerage firms, offering them more products and services, which, in turn, makes the service provider more important to a brokerage firm’s success.
“Correspondent clearing is in vogue, and [Fidelity] wants to be No. 1″ in the business, he says. The first trend is consolidation in the brokerage industry, with banks gobbling up broker/dealer firms, as well as consolidation within the clearing industry. Second, he says, is “an acceleration” of brokerage firms’ shift to a fee-based model. The three basic fee-based models he sees wide use of are a mutual fund wrap with an asset allocation that levies a fee; separate accounts with separate money managers charging a fee; and individual reps who bring assets in a number of accounts or households, with a fee based on assets under management “What’s important about [a fee-based model] from the clearing point of view is that we have to assist the broker/dealers that we deal with in building a sustainable fee-based model, one that economically works for the B/D and works for us.”
The high-net-worth market as it relates to the generational transfer of wealth in the next 20 years will boost clearing firms’ retirement account business, Benzie says. Fidelity is creating and upgrading technology that provides statements tailored to high-net-worth clients, as well as a “system that allows the B/Ds to analyze the assets and asset allocation of our customers.”
Benzie says Fidelity has been enhancing its technology to create “smarter, more flexible technology.” The firm is making sure its statements are faster; that statements are accessible online, and customers are able to “cross collateralize and link accounts under the same Social Security number.”
Fidelity is also making sure that it’s viewed as “a business partner, not a vendor,” Benzie says. Fidelity is using its Practice Advantage program to help brokerage firms become more efficient. For instance, he says, “We’ve gotten a number of retailers airborne, and we help our customers get discount shipping costs by consolidating everything into Practice Advantage.”
Nowadays, it’s also imperative for clearing firms to help broker/dealer clients comply with regulations. “Whether it’s the U.S. Patriot Act or protecting [broker/dealers] from the rogue broker, or something as simple as order entry,” clearing firms have to ensure they have the proper systems, Benzie says. Brokerage firms are sensitive to risk management these days, he says, because “nobody wants to be seen in a light other than pure white.”
The Legacy of Terror
After 9/11, the ability to recover from disasters is also commanding more attention. Fiserv’s Beriault says it’s important for advisors to assess a clearing firm’s ability to respond when crises strikes. “The smaller the firm, the less investment [there is] in disaster recovery,” he says. “Not that they couldn’t cope, but they may not be able to cope as quickly and seamlessly as the introducing [independent broker/dealer] firm would like.” When advisors think about who’s clearing their business, adds Pershing’s Jones, “you have to ask yourself, ‘What if?’” Disaster planning is expensive, he says, and “I do sense that’s why small clearing firms are saying, ‘That’s not a good use of my capital.’”
Yet another regulatory issue that Jones is watching is books and records regulation, which takes effect in May and requires firms “to save more information on customers.” Clearing firms will be required to readily respond to regulators’ demands for such information, which means firms will have to invest in “more technology space capacity,” Jones says.
Jones says he’s looking forward to this year. Despite having a “difficult” year in 2002, he says, Pershing “gained market share [in 2001]; our main competitors lost market share.” While trades were down last year, new accounts opened at brokerage firms that clear through Pershing saw “a 16% year-on-year growth.” And new retirement accounts at the brokerage firms are up 18%, he says. “The B/Ds that we work with are doing an excellent job in attracting new business.”
This year, Pershing plans to offer a separate account from Prudential Advisors to independent broker/dealers (ING is now beta testing Prudential Advisors’ separate account). Pershing’s Net Exchange Pro, a new version of the firm’s online desktop platform, will be released this year as well, and will include access to NaviPlan’s portfolio accounting software. The “new version is more intuitive, and offers more content in terms of information suppliers and modeling, which is what advisors want,” Jones says.
Meanwhile, Fiserv will be putting the finishing touches on a new technology platform from CSS Technologies. “It’s a real-time, Microsoft-based system that runs on NT servers,” Beriault says. “We will be the largest clearing firm up and running on that system in 2003, and we do believe it gives us competitive advantage, as well as our customers, on the front end.”
While Fiserv doesn’t offer services like synthetic collars, the firm’s strong suits are clearing, processing of trades, and providing front-end technologies, he says. Advisory firms tend to gravitate toward Fiserv, he says, “because we do asset-based prices versus ticket charges. We try and match the revenue flow of the customer to ours, so as we grow his business, we don’t saddle the advisor with a lot of fixed costs up front.”
If you haven’t done so already, it’s probably wise to make a list of the services your clearing firm is–and isn’t–providing. Advisors are increasingly realizing they’re dealing with the wrong clearing firm, says Bear Stearns’ Suber, because “they are unable to keep their best and most sophisticated clients, and are unable to get new ones.” Now that many clients have suffered financial downturns, adds Pershing’s Jones, they want more information on the best products, and “are more interested in moving to a fee-based relationship with an advisor.” These factors are “driving the advisor to have to be more qualitative about who he’s associating with in terms of an introducing [independent] B/D or directly with a clearing firm.”
If your clearing firm isn’t measuring up, now might be a good time to switch. Pay close attention to such critical measures as technology investment and product menus, however. You’ll want the firm you select to be around for the next bull market–and several more beyond that.