To the extent that it gets ink at all, the securities clearing business is often described in terms that bring to mind Francis Fukuyamaâ€™s famous â€œEnd of Historyâ€ thesis. A State Department wonk when Eastern Europe broke away from the Soviet Union in the late 1980s, Fukuyama turned Marxism on its head by declaring that liberal democracy â€“ apparently the last ideology left standing â€“ was the inevitable end-point of human political culture, and that, as a species, we were well on the way to reaching that terminus.
Though Fukuyamaâ€™s idea looked promising for a while, events of the last 15 years suggest that he was wrong to suppose that a view of the world as it appeared for a couple of days in December 1988 was a true image of eternity.
Nevertheless, reporters on the look-out for a story about brokerage clearing have found a similar end-of-time air that seems to have been freeze-dried two or three years ago. This familiar tale holds that when brokerage trading was deregulated in 1975, the compression of transaction costs led to a wave of mergers and acquisitions that culminated a few years back. Now the market is dominated by three or four firms that bestride a narrowed world like colossi, elbowing one another for market share in a highly commoditized, thin-margin arena by upping their overall service and technical support for brokerages and reps alike.
Of course there is truth in all of this. The removal of commission controls has had a dramatic impact on the brokerage business as a whole. In the last decade alone, the average unadjusted cost of a stock transaction has fallen by 75 percent. Price erosion on such a scale is bound to send small or otherwise vulnerable players into the arms of bigger partners, or out of the business altogether. Indeed, according to a study published last year by TowerGroup, a Needham, Mass.-based research firm, the number of individual clearing firms fell from about 130 at the end of 1995 to around two dozen by early in 2005.
It is tempting to make this 80 percent overall drop in the number of providers the focus for a discussion on the clearing business. However that approach risks obscuring the fact that clearing remains a vibrant and evolving space with a sufficient number of culturally diverse providers to meet the needs of a variegated marketplace â€“ with some room left over for nimble start-ups.
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In the securities industry, â€œclearingâ€ is the process of getting the money promised as payment for a security into the pocket or bank account of the seller. â€œSettlingâ€ refers to the subsequent transfer of the security to the buyer, whether thatâ€™s done physically or as a book-entry transfer.
Though clearing is obviously an element of every transaction ever conducted, the notion of clearing as a separate and distinct function of securities processing is relatively new.
In its infancy immediately after the Revolutionary War, Wall Street securities trading was a comparatively simple affair. Dealing in the few issues up for grabs â€“ government-debt bonds and a couple of bank stocks â€“ was done in the shade of a mature buttonwood tree on the busy portside road. Frequently the agreements were made and the securities were exchanged for cash â€“ or some acceptable equivalent â€“ right on the spot. At other times, the parties would agree to complete the transaction later on the same day, giving the buyer time to fetch money from his bank, or the seller a chance to lay hold of the security certificates. There was always the risk, however, that one party â€“ usually the buyer â€“ would come to view an agreement reached in the early hours of the day as a poor bargain by lunchtime. Thus instead of honoring his commitment by completing the transaction, he would slip into the crowd and wander, perhaps whistling, up Broadway.
To avoid such shenanigans, a group of 24 securities auctioneers and agents got together in 1792 and signed the two-sentence â€œButtonwood Agreementâ€ to fix maximum commission rates and establish a members-only club for trading securities. Within a year the club was holding its meetings indoors, in the backroom of a Wall Street coffee house called the Tontine, with auctions held just once a day.
It is easy to imagine that the clubby world of the Tontine was not screaming out for dedicated clearing services. Such matters, pointedly, were handled entre nous.
Nor was there a resounding call for clearing to become a separate function in the trade and transfer of securities throughout the still-nameless clubâ€™s formative years. That said, the new exchange was kept busy enough facilitating the trade of government bonds on debt from the War of 1812, and helping to fund the creation of something like 40 new banks in the first twenty years of the nineteenth century. Later, with auctions occurring twice daily, the newly named New York Exchange Board would be an important source of capital for the countryâ€™s vast and rapidly growing infrastructure build-out, first in waterways, and later in railroads.
Even with the introduction of all-day trading at the end of the Civil War, clearing at the newly renamed New York Stock Exchange was still just a matter of the members, a group of men known and accountable to each other, getting together after the bell to confirm their accounts. The actual banking of the payments and delivery of the securities took place over the next few days, with minions doing the legwork.
By the late 1800s, the need for specific processes around clearing became apparent, due to ballooning trading volumes, and nineteenth-century advances such as the telegraph, the stock ticker and the telephone. The sheer pace of business was already making trade processing a more impersonal undertaking when the NYSE opened the door to further estrangement by allowing members to sell their seats.
In 1920, the exchange created the Stock Clearing Corporation to establish a single system for delivering and clearing securities among members, banks and trust companies.
Though this may have proved helpful from a procedural perspective, it did little to lessen anyoneâ€™s burden. This prompted some brokerages to outsource the clearing function and its attendant headaches to other brokerages, who took on the extra workload as a sideline, thereby establishing â€œfully disclosed,â€ â€œomnibus,â€ or â€œcorrespondentâ€ clearing as a specialization distinct from general securities brokerage.
In the years that followed, the investing public were chastened by the excesses of the Roaring Twenties, soured by the Great Depression, and sidelined by World War II; nevertheless by the mid 1950s, they seemed to have regained confidence in the stock market, and in 1954 the Dow Jones industrial average finally poked through highs previously seen only in the run-up to the Crash of 1929.
By the late 1960s, the NYSE was handling 10 to 12 million trades a day, up from an average just a few years earlier of 4 million trades a day. Unfortunately, its member firms werenâ€™t equipped to cope with such brisk business, even with their back offices going around the clock, and as a consequence the exchange began trimming its trading hours.
Partly in response to this â€œPaperwork Crisis,â€ the NYSE established the Central Certificate Service in 1968, which enabled securities to be transferred electronically, eliminating the need to handle certificates physically for settlement purposes. Although this may have eased the task of trade settling, it did little to make clearing any easier. In addition, the CCS was hobbled by the refusal of some of the big clearing banks to play along, mostly because they feared that the CCS lacked industry oversight and the wherewithal to make good on liabilities.
The NYSE responded by forming the Depository Trust Company, or DTC, in an attempt to bring the banks around. It worked, and in 1973 the DTC assumed the stillborn CCSâ€™s job of â€œimmobilizingâ€ securities as well as completing their book-entry delivery. Once again, this step toward centralized and automated transaction processing made the job of settling a lot easier, but clearing was still stuck firmly in the era of Bartleby the Scrivener.
Redundancy is the curse of large-volume clearing. Suppose in the course of a trading day, Broker A has occasion to sell ten shares of XYZ Corporation to Broker B, who later that day sells ten shares of XYZ back to Broker A. If these brokers could get together and â€œnetâ€ their trades, the net change would be â€œno movementâ€ between them of shares in XYZ. All they would be required to do is account for the prices differences in the security rather than having to account â€“ and cut checks â€“ for each and every transaction, including those that cancel one another out.
Unfortunately, brokers trade with too many others in the run of the day to make netting feasible. At least thatâ€™s how it appeared until the NYSE, the American Stock Exchange and the NASD established stand-alone clearing and settling entities to net trades made in their markets. In 1976, the three bourses merged these clearing utilities to form the National Securities Clearing Corporation, and over time the regional exchanges handed clearing and settling over to the NSCC as well.
The benefits of multilateral netting and security immobilization were apparent from the start. Instead of fulfilling redundant contracts or having to work broker-to-broker to net the dayâ€™s transactions, the brokerage firms simply sent notices of changes in security ownership to the DTC. Meanwhile the NSCC reduced the daily dollar amount of financial obligations between traders by about 95 percent â€“ a real boon considering the subsequent explosion of trading volumes. In 2005, daily trading volume on the NYSE averaged 1.61 billion shares.
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There are more than 5,100 registered broker-dealerships in the U.S., according to the NASD, which years ago ditched the name â€œNational Association of Securities Dealersâ€ and took the bare initials as its official title. However, according to Matt Bienfang, a senior analyst with TowerGroup, as many as 1,500 of those entities never use their brokerage licenses for one reason or another.
Of the remaining 3,500 or so who do use their brokerage licenses, 350 to 400 are self-clearing, and 500 to 700 are institution-only players who do not require retail-level clearing services. That leaves something in the neighborhood of 2,500 broker-dealers in need of a clearing firmâ€™s services. â€œBetter make that 2,800 to 3,000,â€ says Bienfang, author of several 2005 reports on the clearing business. â€œThese are very rough numbers,â€ he added.
By everyoneâ€™s reckoning, Pershing, a unit of the Bank of New York, is the biggest clearing-service provider in the business. Founded in 1939, Pershing was the first specialized clearing firm set up to clear NYSE trades for mostly out-of-region brokerages. In addition to supporting full-service brokerage firms, many of them in the bank channel, the Jersey City, N.J.-based organization provides clearing services to registered investment advisors and to institutional firms.
National Financial Services, a subsidiary of Fidelity Investments, is the second-biggest clearing firm with â€œmore than 350 clients, ranging from retail broker-dealer[s] to institutional investment firms,â€ according to a blurb on the Boston-based firmâ€™s website.
Bear Stearnsâ€™ Global Clearing Services is number three, if we go by its number of correspondents. â€œWe have 300-and-something clients,â€ says GCS president Richard Lindsey. More to the point for Lindsey, New York-based Bear Stearnsâ€™ clearing clients are unusually large.
While Bear Stearns quite rightly counts itself as the third biggest clearing firm overall, Wachovia-owned First Clearing claims, quite plausibly, to be the third biggest retail clearing outfit.
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Someone looking for an overview of the clearing business could do worse than leaf through Penson Worldwideâ€™s August 2005 S-1 filing with the Securities and Exchange Commission.
Dallas-based Penson is the fourth-biggest clearing firm with about 225 mostly online and direct-access correspondents, including 165 in the U.S, 40 in Canada and 20 or so in the U.K. Founded as a pure-play clearing firm when it launched with three correspondents in 1995, Penson counts as its principal competitors Pershing, National Financial and Bear Stearns, as well as Merrill Lynch and Goldman Sachs, who acquired the clearing firm Spear, Leeds & Kellogg in 2000.
â€œMany of our competitors have significantly greater financial, technical, marketing, and other resources than we possess,â€ Penson says in its prospectus summary. â€œThese competitors may be able to respond more quickly to new or changing opportunities, technologies, and client requirements, and they may be able to undertake more extensive promotional activities, offer more attractive terms to clients, and adopt more aggressive pricing policies than ours.â€
Despite this vulnerability, Penson sees growth opportunities in several emerging trends. Among these are the general increase in trading volume, the increasing popularity of brokerage-support outsourcing outside the U.S., the rise of multiple-market, multiple-currency trading, and the mounting demand for better reporting capabilities and technologies that integrate front-, middle- and back-office systems.
Penson is also calling for industry consolidation to continue, another trend it sees as working to its overall advantage. â€œAlthough the significant effort and potential business disruption associated with conversion to a new clearing firm may discourage correspondents from switching service providers, consolidation among clearing service providers has led to forced conversions,â€ Penson notes in its S-1 filing. â€œThese conversions result in opportunities for correspondents to seek competing offers and, therefore, for service providers to solicit new correspondentsâ€™ business without having to overcome the difficulties of moving from an incumbent.â€
Mind you, Penson might see ongoing M&A activity in the clearing space working directly to its advantage as well. Last year, it predicted that its acquisition of Glendale, Calif.-based Computer Clearing Services would â€œboost [its] rapid growth over the past decadeâ€ â€“ and pointedly left the door open to further takeovers.
At present, Penson is in a quiet period in the run-up to its initial public offering.
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If Pensonâ€™s story is encouraging to start-ups and other small clearing firms, you can bet that North American Clearing is also paying it close attention.
Though also founded in 1995, Longwood, Fla.-based North American has not matched the spectacular rise of Penson. Instead it limped along in the early years with just six or seven correspondents. Nevertheless, CEO John Busacca claims that the firm has pushed ahead recently, going from 15 clients in late 2003 to about 60 at last count.
This success is based on a strategy of â€œtargeting broker-dealers that the larger clearing firms are kicking outâ€ in the wake of their mergers. Busacca underlines that there is a lot of competition even for small-fry brokerages, and not just from other small clearing firms. He points out that North Americanâ€™s advantage in head-on fights for new business with big players like Pershing and National Financial comes down to three things: lower prices, technical dexterity and personal service.
The issue of North Americanâ€™s pricing is fairly straightforward, but closely connected to its technological offerings. â€œWe offer competitive pricing,â€ Busacca says. â€œBut we also build the interfaces and services that our correspondents need to do business they way they want to do business.â€
On the personal-service front, Busacca says that he makes a point of leading North Americanâ€™s sales efforts. â€œThe CEO of Pershing isnâ€™t routinely talking face-to-face with a ten-man broker-dealer out in Delaware. I am.â€
According to Buscca, this culture of personalized service goes beyond the sale and into the firmâ€™s everyday procedures. â€œIâ€™m the only one at North American who has voice mail. And we always pick up the phone by the second or third ring and speak directly with our clients.â€ North Americanâ€™s aim apparently is to be â€œlike a clearing firm back in the 1980s when people actually answered the phoneâ€ and helped clients through problems on the spot.
TowerGroupâ€™s Bienfang says he is not surprised to hear of North Americanâ€™s new success, which he attributes in part to a â€œbacklashâ€ on the part of broker-dealers disgruntled with industry consolidation. â€œOn face value, there might not be room for another firm,â€ he says. â€œBut there is always room for a good firmâ€ that answers the needs of niches in the marketplace.
Bienfang says there is also room for tiny, even marginal, clearing firms â€œwith one or two principals and five or six clientsâ€ that make sure the broker dealers get the clearing services they need, while the clearing firmâ€™s principals take home a decent paycheck, and perhaps garner a nice payout on selling the company.
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For Bienfang, however, the main issue in the clearing industry isnâ€™t the emergence of de novo clearing firms against a backdrop of consolidation. Rather, itâ€™s the cultural differences between the big-name players that in some cases are traceable to their corporate roots.
â€œIf you look at the strategy of National Financial, itâ€™s very much organized to cater to brokers in a way that is quite different from Fidelityâ€™s business approach.â€ He continues: â€œGoing back to Pershingâ€™s roots, it didnâ€™t have the distribution channels before Donaldson, Lufkin & Jenrette; and then the Bank of New York came along, so itâ€™s much more product-oriented.â€ Bear Stearns and First Clearing, meanwhile are culturally â€œvery much in the full-service space.â€
Corporate culture comes into play in other ways as well. Pershing, historically a clearing firm pure and simple, seems instinctively to appeal to the broker-dealer, whereas National Financial and Fidelity, at base direct-to-consumer fund companies, seem eager to engage the individual representative. Bear Stearns, an investment bank, concentrates on fat-cat correspondents. According to GCSâ€™s Lindsey, its average RIA clearing account is $1.1 million versus an industry average of around $300,000.
Naturally, the big players in the clearing game also slice and dice the market differently. Pershing and National Financial are big in the small-to-midsize broker-dealer space, with Pershing also a favorite among bank-based broker-dealers. As mentioned earlier, Penson does well in the discount arena. Bear Stearns has staked out high-end brokers and RIAs, as well as hedge funds and family offices.
First Clearing is also looking resolutely up-market. â€œThe growth segment we see is represented by firms that are moving away from being old-fashioned stock-and-bond traders to becoming wealth managers,â€ says William Coppell, who runs Wachoviaâ€™s Richmond, Va.-based clearing unit.
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However, once you get past important distinctions around culture and market segmentation, the differences between most clearing firms begin to blur â€“ or so it appears from the outside.
Pershing, National Financial, Wachovia, and Bear Stearns all offer brokers working off their platforms a deluge of services beyond the usual middle-office interfaces. The aim, says Pershingâ€™s CEO Richard Brueckner, is to â€œmake the world safe to compete with the biggest players.â€
In their attempt to put regional and independent brokers on a level with their wirehouse peers, clearing firms give brokers access to desktop programs touching nearly every facet of their work lives, from proposal generation to directed-trust and estate-planning services. Standard offerings also run to investment platforms and manager research, variously described as â€œbest of breedâ€ or â€œopen architectureâ€ to underline the clearing firmâ€™s disinterest in the advisorâ€™s ultimate choice. Other services include strategic consulting in everything from compliance to practice and business-transition management.
In fact, Norman Malo, Boston-based National Financialâ€™s CEO, believes the range of vendor choice his firm gives brokers makes it more than a match for wirehouse reps. â€œI definitely see that broker-dealers are looking for solutions that give them access to multiple providers,â€ he says. â€œThe idea is to keep your identity and serve your clients and use a dynamic platform that offers multiple vendors for everything else.â€
Busacca of North American Clearing isnâ€™t impressed by the broad offerings of his larger rivals. â€œMost broker-dealers donâ€™t care about all those lollipops [the bigger firms] give out,â€ he says. In fact North American avoids getting between broker-dealers and outside vendors, even as an introducer. â€œWeâ€™re not comfortable with that because we donâ€™t ultimately take the responsibility,â€ he adds.
As for investment research and intellectual capital touching on business management, â€œmost of that is available on the Internet,â€ says Busacca. â€œThe way we look at it, our clients know what theyâ€™re doing, and if they need something, they know weâ€™ll try to build it for them.â€
OUTBOX â€“ The Future of Clearing
When looking to see the future of clearing it is best to look at Pershing. With by far the largest client base, Pershing is spearheading the growth of U.S. clearing services to financial firms around the globe. The globalization of the financial industry is still in its infancy, but it is obviously the future and Pershing is not missing a beat. At a recent show hosted by Pershing one quickly noticed an international flavor to what one would normally expect a more domestic appeal. â€œOver 10% of our attendees are from outside the U.S.â€ said Ronald Fiske a managing director at Pershing. Of course all clearing firms are heavily focused on domestic growth as well. â€œWe deliver products and services to help advisors create growth in accounts and top-line revenue.â€ Adds Mr. Fiske. Clearing firms will continue to be the lynch pin of any firms back office. As new investment products, regulations and technologies permeate through the financial industry, clearing firms will try to implement solutions for their customers on how to manage them.