Death of the Small Broker-Dealer

Death of the Small Broker-Dealer

by Richard A. Roth and Craig B. Tepper

Over the past decade, a tremendous amount of pressure has been laid on the shoulders of the small broker-dealers of the securities industry. Like the iconic Willy Loman in Arthur Miller’s Death of a Salesman, these small and/or independent brokerages are allotted a significantly shorter leash than they have been in years past, and because of it, they are rapidly becoming the endangered species of the securities jungle. The statistics are plain and simply frightening; according to [1], citing research by The Compliance Department, the number of independent broker/dealers will shrink from 4,555 firms in 2012 to 4,000 by 2015. Annually, almost twice as many broker-dealers are closing than opening; so called “mom-and-pop” broker-dealers that operate with only a handful of registered reps are dropping like flies. In fact, industry experts anticipate a net average of 14-16 small broker-dealers exiting the industry per month in the coming years.    

A major reason for the increasingly dwindling number of broker-dealers is the immense pressure coming directly from securities regulators. In response to the most recent financial crisis, the SEC approved a new FINRA regulation, Rule 4524 [2], which exponentially increased the amount of information that FINRA-registered broker-dealers are obligated to report. Before Rule 4524, both the SEC and FINRA utilized special programs to monitor FINRA-registered firms and to ensure that such firms had the appropriate amounts of liquidity and leverage to meet their needs. However Rule 4524 now requires all broker-dealers to bear the burden of an incredibly labor-intensive information-gathering process. Under the Rule, broker-dealers will be obligated to file Supplemental Statements of Income on a quarterly basis, consisting of tediously detailed reports of revenue and expense line-items. In order to get these reports to FINRA on time, broker-dealers have had to completely restructure their system of information-gathering and compliance, requiring a collective effort between the accounting and administrative departments, and the registered reps themselves. For small broker-dealers without the manpower to dedicate to such a time-consuming process, it has proven difficult, and in many cases impossible, to keep their heads above water. 

Another significant factor contributing to the demise of small broker-dealers is that the perpetually competitive securities industry is severely cutting commissions. While the worst of the financial crisis is behind us, the stock markets are still a far cry from their glory days of old. Because of this, broker-dealers are constantly racing each other to the bottom in order to provide traders with the lowest possible commissions. Average commission rates have gradually decreased on an annual basis; in 2009 broker-dealers received an average of 2.9 cents per trade, but as of 2012 rates have fluctuated from as low as 2 cents to a fraction of a penny per trade. Medium and large-sized broker-dealers are able to employ enough registered reps to stay competitive despite these shockingly low commission rates, a luxury that small broker-dealers simply don’t have. For those independent brokerages who manage to make ends meet, they still must face the constant threat of losing business from customers who are simply too apprehensive to pay commissions to a broker-dealer that might close its doors within the next few years.

In addition to these daunting market-trends, the SEC and FINRA are proactively going after small broker dealers. In an article we wrote last year entitled Regulators Go After Little Firms, It’s an Easy Win [3],” we discussed how the regulators, “rather than going after power-house firms, instead ‘show their muscle’ by proceeding against small firms, knowing that these firms are more likely settle, as many of them are financially restricted from fighting regulatory actions.” Based on their behavior, it seems evident that the regulators have no intention of aiding small broker-dealers, and instead are taking a proactive role in their plight.

If the downward trend continues, which is highly probable, small brokers will likely need to take emergency steps to restructure their business in order to survive. One life preserver that has proven effective is mergers. Over the past few years, many independent broker-dealers have sought this path to stay afloat. In fact, a study released by Wealth Management [4]in February of 2012 shows that the number of FINRA registered broker-dealers has decreased 88% since 2005, but the number of registered representatives has only decreased slightly over 3%, clearly indicating that brokerages have had to rely on mergers to keep their reps in the field. By merging, independent broker-dealers can significantly cut down on costs, saving them anywhere from 10-15% of expenditures. Another emergency measure broker-dealers have taken to stay afloat is to transition to a fee-based business model, and no longer force them to rely on commissions, which are, as already discussed, at a shockingly low level. By taking this step, these broker-dealers essentially cease participating as broker-dealers at all, instead, as Investment News phrases it, becoming investment advisers. The aforementioned Wealth Management study predicts that, within three years, fee-based income will account for over 55% of business for small broker-dealers, while commissions will reduce to only 36.4% of their business. By charging fees for investment services, it can guarantee a much needed influx of cash for the mouths all of the brokerages have to feed.

Due to immense pressure from the SEC and FINRA to restructure compliance departments, and extremely competitive commission rates, broker-dealers will most likely be forced to take extreme survival measures, such as restructuring business models or seeking out other firms with whom to merge. While the securities industry will continue to “fight the good fight,” it will only delay the inevitable: the impending extinction of the small broker-dealer.