House Hunting

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.”