FLASH FRIDAY: Clearing Firms Focus on Technology to Stay Competitive

FLASH FRIDAY is a weekly content series that looks at the past, present and future of capital markets technology and trading. FLASH FRIDAY is sponsored by Instinet, a Nomura company.

In 1998, there was a Traders article stating that clearing is still a potentially lucrative business for well capitalized brokers.

What is the state of the compensation industry in 2022? Is it still profitable? According to Brett Thorne, president of RBC Clearing & Custody, competitive pressures and the commoditization of merchant services “keep margins thin.”

Brett Thorne

“However, with the right scale, the right technology, and perhaps most importantly, the right people, clearing can be profitable for a well-managed clearing provider,” he said. Capitalization can be an important consideration, especially during periods of market volatility, she said.

Will Thomey, co-director of business development for Acadia, added that profitability depends on perspective. Clearing businesses within many major financial institutions are seen as important businesses to fully support their clients, but the profit margins on these businesses are not always as lucrative as in other areas, he said.

He added that the most successful clearing brokers have invested in technical and operational capabilities to enable scale, seek to improve collateral optimization, understand the connections between how their franchise operates relative to their cost of capital, minimize client-specific deals ( both commercially and operationally), and are capable risk managers (preventing potential losses from default or operational errors).

“Currently there are tailwinds for clearing business as macroeconomic conditions have led to higher trading volumes and higher interest rates (which generally leads to improvements in the NII),” he said.

Clearing firms can generate a decent return on capital if done right, according to a spokesperson for Apex Fintech Solutions. To be successful, a clearing firm is required to have excellent processing tools that can scale along with employee expertise to ensure regulations are followed and client assets are protected.

“Companies will need to continue to innovate to provide clients with products and solutions that provide a frictionless investment experience.”

As early as 1998, a consolidation trend was observed in the clearing space. In 2022, 24 years later, consolidation remains a trend that seems to be a constant topic of conversation among brokers, Thorne said. “As the cost of doing business continues to rise, the burden of regulation continues to grow, and the challenges of operating a brokerage house continue to increase, we don’t see the consolidation trend slowing any time soon,” he emphasized.

Another related trend, Thorne said, is that many independent financial services providers are giving up their broker-dealers and switching to the registered investment adviser (RIA) business model. “This is due to the same pain points that force brokers to consider consolidation. So being able to provide custody solutions is becoming a more important service for clearing providers,” she said.

The forces at work driving consolidation and change to serve clients like an RIA are also driving two employment trends seen across the corporate world since the start of the pandemic: the war for talent and rising cost. of labor, Thorne said. “The compensation business relies on employees who have a highly specialized skill set.”

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Thorne argued that the trend with the broader impact may be that “technology is playing an increasingly important role” in daily operations and the way services are delivered across the financial services industry.

“More than providing transactional support and keeping books and records, clearing companies are becoming a go-to source for tools and systems,” he said.

Thomey agreed, saying that operationally, there is a more concerted effort to improve automation. As market silos continue to erode, companies are realizing that while the cleared OTC/F&O market has elements of standardization, the operating environment should be simpler (especially relative to the uncleared OTC market). , He said. “However, the amount of investment in automation has lagged behind, leaving infrastructures/processes/disconnected and limited workflow to digitize interactions between Clients/Clearing Brokers/Exchanges/CCPs through trade management (or position ), margin and liquidation,” he said.

Additionally, Thomey said that given the macroeconomic environment in recent months, volatility has increased and risk management has re-emerged as a focus across the industry. “This includes looking at the level of margin/collateral held (and affiliated initial margin models/calculations), as well as industry-wide default management practices,” she said.

challenges

The biggest challenge for CCPs is the continued demand for real-time processing, said an Apex Fintech Solutions spokesperson. “Not too long ago, it used to take five days to settle a stock trade. Now we have two days left and plans are underway to get to one day by 2023.”

“We are also starting to see a growing demand for 24/7 trading in traditional markets, such as exists in cryptocurrencies. CCPs and clearing firms should continue down the path of 24-hour trading capabilities and near real-time settlement, as this style of trading feels inevitable at this point.”

Will Thomey

According to Thomey, there are a variety of challenges largely related to disparate data. A clearing broker has to deal with inconsistent data representations between exchanges or CCPs without any standardization regarding connectivity (for example, the industry lacks standard APIs), she said.

“This presents challenges in trade management (getting trades executed, allocated and settled correctly), ongoing book and record reconciliations, and reference data maintenance (instruments, risk matrices, etc.),” he said.

Furthermore, according to Thomey, clearing companies are subject to different operating models required to deposit collateral with an Exchange or CCP. “This operational drag leads to suboptimal collateral allocation,” he said.

He added that replicating margin calculations is complicated (given the differences between Exchanges/CCPs), further complicating the ability of all participants to optimize risk and reduce related costs.

Thorne argued that responding to technological changes occurring in financial services is a “big problem” for many clearing firms. The challenge falls into three categories: cost, connectivity and competition, he said.

The development of new technology, the adaptation of standard technology and the retirement of legacy technology can require a significant technology budget for financial services firms, Thorne said.

“The faster they need to achieve a technology goal or the more complex the work to achieve it, the more companies will have to spend. Offset providers are looking for ways to help the companies they serve control and reduce technology costs,” she said.

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Thorne added that beyond the nuts and bolts of technology development, there is the challenge of how financial firms integrate new solutions into their existing technology stacks. The technology is meant to make tasks easier and help improve outcomes, but if the tools don’t communicate with each other, “the technology can become a headache” for users instead of simplifying their tasks, she said.

“Clearing firms must offer technology platforms with the flexibility to work with many different systems,” he added.

Thorne highlighted that another challenge is the generational change on the horizon of the financial industry.

With retirements on the horizon for many key people in the industry, the company’s management will transition to younger leaders and younger producers will need to enter this business, he explained.

“For these next generation firm directors and finance professionals, technology may be a determining factor in terms of who they choose as their compensation provider,” he said.

“They are looking for technology from clearing providers that helps improve their relationships with clients, such as planning software and mobile access to account information, as well as self-service capabilities that allow clients to save, invest and spend money more easily. ”, he added.

Improve cleaning accessibility

As the securities industry continues to evolve, Thorne said some clearing providers are shedding their smaller broker-dealers because they perceive that the risks of serving smaller companies may outweigh the potential revenue that smaller companies can generate. smaller companies.

“In terms of improving accessibility, clearing providers simply need to do a better job of balancing the rewards against the risks of catering to smaller brokers,” he said.

In support of this view, RBC Clearing & Custody works with smaller firms that can demonstrate a good track record in managing business risk and running a clean business.

“In fact, we believe there are many benefits to working with smaller brokers. They can have high-quality financial professionals with fewer compliance issues because they know their representatives better. Also, many profitable small businesses have competent staff where turnover is low,” he said.

An Apex Fintech Solutions spokesperson said improving the accessibility of compensation for introducing brokers, non-traditional firms and retail investors themselves is done by providing a “frictionless experience”. Clearing firms that can provide turnkey, integrated platform solutions for these entities and their clients to make the experience seamless, level the playing field so everyone can access the markets and have the tools to accumulate wealth, he said. a spokesman. “That, combined with continuing education for industry participants, will lead to a better experience.”

Thomey noted that Clearing Brokers (and to some extent Exchanges/CCPs) must be well capitalized entities with adequate “skin in the game”.

“Accessibility should not be improved if there are trade-offs (ie reduced or relaxed levels of margin and/or capital) or less oversight by global regulators,” he concluded.

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