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Industry Spotlight > Clearing and Custodial Firms

Clearing a New Landscape

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It’s no secret that the global financial collapse has pushed vitally important risk management front and center.

And perhaps no other segment of the financial services industry is more focused on certain aspects of this issue than clearing firms.

There are, of course, several types of risk to manage: market risk, credit risk, management risk and so on. It is reputational risk to which clearers are giving their unremitting attention.

“It’s a new world. Anyone who believes that the policies and procedures as written two or three years ago about who they do business with remain adequate needs to examine them. Because of the things that have happened, they require a new level of scrutiny by everyone,” says Jim Crowley, managing director of Pershing, an affiliate of Bank of New York Mellon and, with 1,150 clients, the largest clearing firm.

Clearing has always been a risk business. But since the financial crisis, companies are indeed more intensely evaluating and reevaluating the clients that come through their doors.

“What’s changed is that there’s an increasingly continuous and evolving look at risk,” says Dan Weingarten, vice president and head of global sales and marketing for Penson Worldwide, based in New York City. “We need to make sure that firms match up with the profiles we expected and that their business continues to matchup. If it changes, we’ll go back and ask them for higher clearing deposits or increase rates for the new lines of business.”

At Raymond James & Associates, with 38 clients, specialists have been brought in to focus on counterparty risk relating to all the firm’s outside partners.

“Counterparty risk is the buzzword. Everybody is trying to get more transparency into service-provider relationships and understand their clients better in order to mitigate any potential challenges in the future,” says Robb Combs, director of correspondent clearing, in St. Petersburg, Fla.

“It’s more scrutiny and further due diligence. Probably someone could have done more of that on their relationship with Bernie Madoff,” Combs adds, stressing the necessity of this investigative work.

Sifting out the good broker-dealers from the less-than-desirable has been common practice for clearing firms in establishing new relationships. But today, when even the strongest have failed, it is paramount.

Clearers are being super-careful. “We sometimes find ourselves turning down more firms than we take,” says Craig Gordon, director of correspondent and advisor clearing at RBC Correspondent Services, in Minneapolis, which clears for 170 clients. “That’s not because we think they’re bad people or the firms are doing bad things but that their risk profile doesn’t fit our comfort level.”

Broker-dealers selling derivative securities, in particular, are getting a thorough going-over in view of the damage that’s resulted from their improper sale. Clearers say they must be ever-vigilant about the firms with which they align themselves. For example, First Clearing, a non-bank affiliate of Wells Fargo, with 114 clients, virtually steers clear of BDs using derivatives.

“Over the years, the industry was lulled into a sense of complacency and almost on a robotic basis, processed these products without, perhaps, understanding them at the level they needed to and without preparing themselves to manage the risk associated with them should something occur,” says William Coppel, First Clearing’s chief client growth officer, based in St. Louis.

“It will be challenging for those clearing firms who are playing in the [derivative] space to make sure they’re really scrutinizing the business,” Coppel notes.

On the Upside

Now on to the good news in clearing: firms serving mostly small- to mid-sized BDs have actually benefited from last year’s calamitous upheaval. Wirehouse and bank acquisitions have brought a huge, steady advisor migration out of these institutions and into the independent world. What a boon for clearers, who are helping to recruit.

This shift, says Gordon, “will give a big boost not only to broker-dealers but to the clearing industry. In fact, it wouldn’t surprise me if [eventually] two-thirds of the business will go through independent firms that clear through others and one-third goes through wirehouses — instead of the other way around,” as now.

“We’ve seen a lot of our middle- and smaller-tiered correspondents expanding because they’ve been able to go after the ‘unattainable broker,’” says Weingarten, of Penson, with 300-plus clients. “Historically, it was very hard for a smaller firm to pursue a wirehouse broker with a big book of business because he was established and had a good payout — and wasn’t necessarily looking to leave.”

To be sure, the BD expansion has given a substantial lift to clearing firms, who are helping to build brokerages’ rapidly growing advisor base.

Recruiting big producers out of major firms, some BDs are even doubling their business, Gordon says. “It’s exciting! We’re seeing the traditional wirehouse financial consultant going independent or setting up their own business faster than anybody ever imagined six months ago, when this was predicted.”

He adds: “The stability and strength of some [wirehouses] vanished — in certain cases overnight. It made very successful financial advisors reevaluate what they needed in order to service their clients. And it gave them an out [to leave their firms] and say, ‘Things have changed. I need to have the resources to meet your needs. I can do that at an independent firm with a strong clearing partner.’”

National Financial, a Fidelity Investments company, with 310 clients, is helping clients recruit wirehouse advisors to “soft-transition them to being on their own and to help with the conversion process,” says Mark Healy, executive vice president for client management.

As a result of last year’s M&As, National Financial, according to its competitors, lost some big accounts — most prominently, Bank of America and JP Morgan Chase — which now have their own clearing entities.

However, Boston-based Healy says that “until those organizations have made a decision to internalize [clearing operations], we’ll continue to serve them, for sure, for the next years to come.”

A Turn to the Self

At the same time, National Financial is moving swiftly into another facet of the clearing business: self-clearing. Healy, appointed to his newly created position in April, was previously National’s chief operations officer and developer of the company’s self-clearing platform. Before that, he was Fidelity’s institutional brokerage group chief financial officer.

“Even before the macro [crisis], a few years ago we undertook an initiative to build out a unique self-clearing offering that allows firms to take more control over their clearing [needs]. This year we launched it. We see this as part of the future growth of our organization and of the clearing industry,” Healy contends.

“We have a very strong strategy around this offering and feel it will mitigate any acquisition activity that may occur,” says Healy, noting that the self-clearing market holds about $13 trillion in assets versus the fully disclosed market’s $2.5 trillion.

National Financial has also placed renewed stress on helping its institutional-business clients grow. “Once retail trades were down and retail was facing a challenge, the institutional practices were really thriving and balancing out the loss of revenue….” Healy says. “We see great opportunity in continuing to invest in that area.”

President Obama’s financial reform program is certain to impact the clearing industry, though it’s too early to pin down specifics. Chances are good, however, that heavier regulation and more stringent oversight will be on the menu.

RBC’s Gordon predicts that more “burdensome” regulations are en route, especially for registered investment advisors.

That, he speculates, might be great for clearers. “There could be an opportunity if regulations for broker-dealers and investment advisors were moved under one umbrella. This could mean that the investment advisory community will say, ‘If we have the same responsibilities, we might as well be part of a broker-dealer — or, for that matter, become a broker-dealer.’ So clearing firms that cater to both segments would make out well.”

Coppel concurs that heightened regulation will significantly affect the RIA space. “It’s been very loosely regulated under the auspices of the SEC over the last dozen or so years. We’re preparing ourselves to be sure that we have the tools available to help [RIAs] manage their supervisory responsibility.”

Coppel continues. “We may see RIAs who look and feel more like broker-dealers because of the support [clearing firms] will give them in the areas of compliance and technology to run their business on economics that make sense. It’s expensive to [just custody] assets if you’re a small business.”

Pershing, headquartered in Jersey City, N.J., already has in place an initiative, called RIA Complete, to support the future RIA business model.

“Alternatively, the advisors would seek out an advisory custodial relationship away from the broker-dealer,” notes Crowley. “That means a bifurcated business — or they walk away from the transaction business and go completely advisory.” With RIA Complete, the assets remain at a single independent custodian, Pershing; and FAs have one source for compliance, support, technology and so on.

Other new innovations include advanced advisor workstations on the way from Pershing, Penson and RBC. Raymond James is offering Service Center, a new document-processing system aimed at cost reductions. National Financial is later this year launching an enhanced international capability for handling transactions in 26 countries. And Penson is expanding its execution services into the United Kingdom, allowing United States correspondents to execute directly in the U.K. and Europe.

First Clearing is preparing to unveil a unique income-generating model embracing both product and technology. Notes Coppel: “A third of our population is either in or approaching retirement age. We’ve got to build models and capabilities that support generating income for them based on their investments. That’s a sea change.”

Cautiously Optimistic

The rally that began at the end of February has obviously brought more business to BDs and, consequently, to their clearing partners. “We think that since the market has started to come around, this is a good time for prospects to consider making a change in clearing partners,” Combs says. “We’ve had a lot of inquires in the last two months. There’s fear about [certain] clearing firms’ viability, and service degradation is causing frustrations too.”

Jonathan Eaton, managing director of LPL Financial’s Custom Clearing Services, which clears for AXA Equitable Life Insurance Company’s AXA Advisors, is seeing more interest in its clearing offering stemming from firms’ huge margin pressure and realization that outsourcing can indeed improve the bottom line.

“A new world order has emerged,” says Eaton, based in San Diego. “People see that the pressure on margins and the economics of running a business aren’t going to be relieved anytime in the near future. It’s permanently changed. Commitment-phobes have recognized they need to do something to address this. They’re talking to us, and that’s been a very big change from earlier this year.” LPL, targeting large insurance brokerages, names National Financial and Pershing as its chief competitors.

Assessing the global train wreck of last year, Penson’s Weingarten makes a triumphant point about what did not go wrong: “The financial system took a strain, and the clearing and execution and settlement process came through very strongly.”

Cautious optimism now pervades the clearing industry. “The rally that started the first part of the year has certainly been positive,” says Coppel. “But everyone is very sober about it. No one expects this thing to go flying through the roof back to where we were anytime soon. We’re preparing for a long, steady movement in the market over some undefined period.”

Freelance writer Jane Wollman Rusoff is a Los Angeles-based contributing editor of Research and is the founder of Family Star Productions.


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