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It's Not Just About the Trade

The custody and clearing industry is shrinking. For registered investment advisors and reps alike, that's a good thing.

The custody and clearing business has long been regarded as grunt work, a mundane, albeit important, process that most reps ignored and one that broker/dealers generally farmed out to any number of firms. Indeed, for most advisors, it was viewed — and to some extent, still is — as a mysterious backwater, an area to wade into only if a client's trade went awry. Today, however, because of a massive consolidation wave and a hyper-regulatory environment, financial advisors are interacting with their clearing firms in ways they never did before.

Quite simply: To win business, clearing firms are aiming for you, the advisor. With about 50 percent of the clearing industry now in the hands of just three players, settling trades is a service that is taken for granted by correspondent b/ds. Of course, clearing firms are offering back-office services, but also new investment management platforms and aiding brokers with regulatory compliance and, for smaller b/ds, even training new hires. In short, they are now battling for the desktop of financial advisors.

“RIAs and b/ds are facing mounting challenges, ranging from regulatory pressure to greater client needs, and are demanding that their custodian or clearing firm offer more than just traditional services like trade execution,” says Donna Morris, executive vice president of National Financial. “They are looking for a strategic partner, someone who can deliver a full-range of integrated brokerage solutions that can help them profitably drive growth, reduce costs and manage risk.”

Services such as these, says Jim Crowley, managing director at Pershing, the largest clearing firm in the industry, are “more important to increase the value of our relationships than to just be a provider of executing custody/clearing services — that's not where we want to compete.”

Back in the day, most b/ds that didn't self-clear simply outsourced the process to a smaller, regional-based firm. Now, three big players dominate the sector: Pershing (owned by Bank of New York), National Financial (owned by Fidelity) and Bear Stearns Global Clearing. [But there are rivals, such as software firm Automated Data Processing (ADP).]

The increasingly commoditized business of settling trades is making the business of clearing trades a less profitable one. Margins are razor-thin as the price of trades are falling, now typically executed for under $7 compared with $29 or more a decade ago. Expect trading fees to keep plummeting.

The Great Consolidation Game

Ten years ago, there were roughly 130 firms that performed custody/clearing functions; now there are only about 25. Further, the biggest players have gotten far bigger, and most are aligned with a bank or securities firm: Ruling the roost are Pershing (with roughly 1,100 correspondent b/ds and RIA clients), National Financial (with 358), Bear Stearns (with 342), Penson Financial Services (with 228) and Southwest Securities (with 221), according to a 2005 survey by TowerGroup. Analysts and clearing executives alike expect further consolidation, both among the top-ranked firms, who likely will continue to devour each other, as well as among smaller firms, which are tempting targets for larger clearing firms looking to keep their business growing.

The clearing industry consolidation began in earnest in January 2003, when, after entertaining a number of suitors, Credit Suisse Group sold its Pershing unit to the Bank of New York for $2.5 billion. Three months later, Fidelity purchased UBS Correspondent Service Corp. for $340 million, a deal that added 150 new clients to its existing clearing unit, National Financial's, roughly 170 brokerage customers. Fidelity followed the UBS acquisition in 2004 by acquiring Fiserv's clearing unit — then the clearing industry's fourth-largest firm — for $365 million, netting another 500 clients. And last year, Penson purchased Computer Clearing Services and added 50 new correspondents, bringing its base customer list to 225.

As a result of these moves, a sharply defined hierarchy now exists in the clearing sector, says Steve Samberg, of Southwest. He says that underneath the trio of Pershing, National Financial (which dominates bank brokerages) and Bear (which clears for a large number of hedge funds), there is a second tier consisting of firms like RBC Dain Correspondent Services (with 165 correspondents), Wachovia's First Clearing (with 152 correspondents) and his own firm. And then there is a final tier of smaller firms like Emmett A. Larkin Co. (46 correspondents) and relative newcomer Legent Clearing (33 correspondents). It is this last tier whose future is most in doubt, top clearing firms say. “The question is now whether a regional firm will step up to be a big player, or do these large firms continue to keep acquiring the regionals?” Samberg says.

But Matt Bienfang, a TowerGroup analyst, says it is the top-tier players who will experience the most consolidation to come. “There will be maybe one more big deal to shake things up. Then you'll see some outsider that either was in the clearing business and got out, or a total newcomer, come in and buy their way into the top 10.” Top candidates for going on a buying spree include Citigroup. It launched a correspondent clearing business in 2004, but has yet to make much of an impact on its own.

Among the more ambitious newcomers is ADP Clearing, which vaulted into the custody/clearing industry in November 2004 when ADP's parent purchased U.S. Clearing and Broker/Dealer Services from Bank of America. The firm has recently landed TD Waterhouse and E*Trade as clients.

“I think it's going to be harder for regional firms going forward, and you're going to see clearing firms continue to consolidate,” says Joe Barra, president of ADP. For ADP, the increasing complexity of the clearing industry, and the array of services clearing firms are vying to provide clients, made its move into the sector a logical step, he says. “We process, we outsource, that's all part of our business model, and investing in the correspondent/clearing space is perfect for us,” Barra says.

ADP's in-house software could prove a competitive advantage, rival clearing firms say. Barra agrees that his company's technological edge is key: “It will be increasingly difficult for smaller firms to continue to meet the demands of the competitive pricing environment.”

That said, some clearing rivals to ADP wonder whether the firm's dual role as software provider and clearinghouse could wind up alienating some clients. “I would never do business with them now — they're now competition,” one clearing firm president says.

The need for massive technology investments will continue to separate the dominant firms from the rest, says Norman Malo, CEO of National Financial. Fidelity, National Financial's parent company, reportedly has a $2 billion-a-year tech budget. “The firms that aren't keeping up, will they begin to lose market share and will the dominant players be able to capitalize on that? I think smaller players will, over time, lose some market share,” Malo says.

National Financial symbolizes the heightened ambitions of the largest clearing firms. In the past three years, the firm has increased its market share in custody/clearing to 12 percent from 7 percent, Malo says, half due to its acquisitions and half from new clients. The firm is now handling 250,000 trades a day on average, has custody of around $540 billion in assets and brought in $100 billion in new assets to Fidelity in 2005, the company says.

Expect the rivalry to heat up, as the largest clearing firms' growth is increasingly going to have to come at the expense of their rivals, analysts said. “There is no organic growth in this industry — or if there is, it's when your salesman tries to steal an account from a competitor,” Bienfang adds. And poaching a client from a rival clearinghouse is much harder than it may seem. Many b/ds and advisors say changing clearing firms is akin to getting a root canal — so a clearing firm that wants to steal a client had better be prepared to offer generous terms. “If you don't have to change clearing firms, you don't,” says Southwest's Samberg. “It's very painful. We like to tell clients that we'll take as much pain out of it as possible, but it's still a lot of work.”

New Services, Old Services

So what types of services should reps expect from their clearing firms? The largest clearinghouses are now trying to push into almost every sphere of the business, in an attempt to integrate their clients into using an overall array of products. Take National Financial, which offers a product called Streetscape Dashboard. Streetscape provides “snapshots” of key listings to advisors, such as the top five cash positions. And Pershing is in the process of launching an annuities platform that would take over managing regulatory requirements.

Another change: B/ds now embrace the outsourcing concept. “If you had asked that question 10 years ago, you'd have gotten a very different answer — people would have said, ‘I want to control my own destiny,’” Malo says.

Further, National Financial is now offering to train new hires for b/ds, whether in technological skills or getting reps up to speed on regulatory changes. “The next phase of evolution in clearing is for clients to allow me to train and make their reps more productive,” he says. “This is a change. Ten years ago, most of my clients didn't want me to even talk to their reps.”


The custody business has gotten to the point where the regulatory and legal complexities make it too complex to keep in house, says Bill Tillotson, chairman of Pittsburgh-based financial-planning firm Hefren-Tillotson, which trades mostly through Pershing. “It's gotten to the point where a person is crazy to hold on to any of their own certificates,” he says. “It's a completely different ballgame now.” Further, Hefren-Tillotson's own growth would have been constrained had it not had technology services provided by the likes of Pershing. “We wouldn't have been [able to grow] if we didn't have clearing agents to keep us up to date as far as technology is concerned.”

But for some clearinghouses, commoditization and price competition mean that no matter how complex clearing becomes, it's going to be difficult to truly profit by doing it. “Anybody can clear a trade — the business is not more complex than it was, though we do get more regulatory issues than we did five years ago,” says Southwest's Samberg. “It's getting to the point where everyone wants more for less — clearing firms are doing more and are not necessarily getting compensated for it.”

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