When it comes to clearing and settling trades, there's no lack of competition in the marketplace. The Securities Industry Association's annual yearbook, for example, lists more than 100 SIA firms that clear trades for other firms, including giants like Merrill Lynch & Co., Inc. and Fidelity Brokerage.
But expect the pool of clearing vendors to shrink in the coming years, experts say, as the drive to straight-through processing sweeps the industry and clearing and settlement firms come to grips with the cost of keeping abreast of technological change. It will drive smaller players out and force others to become larger.
It's a "highly competitive market" with "so many players out there" and "razor thin" margins, says Bob Iatti, an analyst with the TowerGroup in Needham, Mass., that it's "likely ripe for some M&A activity."
The industry has seen the effect of consolidation within the clearing and settlement business. According to TowerGroup, in 1998, the top eight clearing firms accounted for 50 million of the trades cleared, by 2000, that number had grown to 350 million trades.
"Clearing is expensive," says Damon Kovelsky, an analyst with Meridien Research in Newton, Mass. "You can't use cheap low-end servers." Even for a medium-sized firm the "hardware is really expensive. You can spend lots of money upgrading this stuff. It's not cheap."
It's that need to continually invest in the technology, combined with the slumping markets, that will drive many firms to re-evaluate their clearing and settlement strategy.
Three Paths to Clearing Nirvana
There are three approaches to clearing and settlement that firms can take. They can do it themselves, using either proprietary solutions or vendor technology, use a service bureau or a correspondent broker.
Those who self-clear, though, Iatti says, face the biggest challenge given the slumping markets. It's "less and less of a popular solution. Only the largest firms can afford to do things in-house." He says there hasn't been a "lot of focus on the back-office technology over the last 15 years." However, the brokerage business has "evolved greatly since these things were built." Volumes have tripled and in some cases quadrupled. The question, he asks, is, "To what extent can a legacy system be an effective processor going forward in the new environment? You have to make changes in order to be STP compliant."
Jerome Dumaine, a partner in the capital markets and infrastructure group at Accenture in New York City, says that since Sept. 11, "People have less money to spend." However, he says, some firms have spent the past 20 years "building clearing and settlement infrastructure little by little, making applications here and modifications there and have created a system that is so convoluted that the cost of doing it in-house is extremely prohibitive."
It's all about deployment of capital and return on investment, these three experts say. Iatti notes that the "back office is viewed as a cost center, not a profit center, and most people don't want to sink a lot of money into them."
That means some of the larger firms will retreat from the self-clearing game and opt to outsource that function, while others will step up to the plate and try to leverage their systems and become better outsourcers themselves.
"I see a lot of firms interested in outsourcing and figuring out ways they can save money," says Tony Scianna, vice president of business development at SunGard Securities Processing. "A lot of firms are realizing that they're not technology firms but brokerage firms and are concentrating on their core efficiencies and letting technology firms concentrate on theirs."
Self-Clearing 'Not Cheap'
If self-clearing, or becoming a correspondent broker, is the "route they want to go, then they're going to have to upgrade (their systems). It's not cheap," Kovelsky says, noting that it's not a case where you "give (your IT developers) a couple of million and see what comes out of it." It means spending millions, he says, noting that creating two to three redundant sites alone is going to cost a minimum "$5 million, not including installations and software. The correspondent clearer has to make sure this is the road they want to go down."
Dumaine says firms need to decide whether being a self-clearer is "something important to the core competency" of the firm. "They need to spend time trying to understand where it is they want to be a differentiator of their offering and how they want to make money in 2005."
Scianna adds that deciding whether to "self-clear or clear through a correspondent comes down to numbers. Can you do it for cheaper and get the same quality of clearance?"
Many will find that they can't and that spells opportunity for firms supplying outsourcing services in the clearing and settlement area.
Service Bureaus Mean More Staff
In the service-bureau space, Kovelsky says, the main players are ADP Brokerage Processing Services, SunGard's Phase3 and Thomson Financial's Beta Systems but when it comes to correspondent clearers, the choices are many.
Picking one route over another "depends on what you're looking for," he says, noting that service bureaus are "still rather bare bones" with few "value adds," while "correspondent clearers put in some value adds."
However, that seems to be changing as service bureaus ramp up and add components to their offerings.
Dumaine notes that service bureaus give you access to technology and you still do the processing. As such, you need more IT staff than you do in a correspondent environment.
Marianne Brown, general manager for ADP's Brokerage Processing Services, says when it comes to picking a service bureau, "Look for ongoing investment of the service-bureau infrastructure." She notes Y2K was a catalyst for firms switching to service bureaus and suspects that T+1 will have the same effect, despite a "vigorous debate" about the merits of moving to one-day settlement. When you "get these things, people revisit the processing environment and it opens the field for opportunity."
Correspondent Clearers Build Better Workstations
When it comes to correspondent clearers, Iatti's firm believes that's where the battle for clients will become most fierce and will center on the ability of correspondent clearers to build out their broker workstations. TowerGroup predicts that correspondent clearers will increase spending on their workstation technology over the next three to five years, rising from $458 million in 2002 to $561 million in 2005, an annual-compound-growth rate of 7.74 percent.
"Firms are outsourcing in greater numbers than ever before, but there is one problem: When firms give up their technologies to a service provider, they lose their cutting-edge skills to develop differentiating and competitive technologies. To keep up requires clearers to virtually morph into technology companies, providing robust and reliable technology to their clients," TowerGroup notes in a recent report on correspondent-clearing-broker workstations. That means correspondent clearers will find it increasingly difficult to satisfy customer demand by only providing rudimentary services."
Factor in that a broker workstation has a shelf life of 18 to 24 months and correspondent clearers will see that, "Technology investment will be critically important" moving forward. That means when selecting a correspondent clearer, broker/dealers need to be convinced that the firm is in the game for the long haul and is willing to make the investments needed.
"It's a catch 22 for some of these firms," says Dumaine. "They are building the next generation of technology and at the same time ... trying to get revenue. Do they wait until they have enough people to sign on and have enough money to start building the next generation or build the next generation and go out and market that?"
One thing firms need to be careful about is the notion of real time. There are a lots of vendor games around the term real time, says Iatti. "It's important to distinguish true real time from the pretenders. You'll hear phrases like true real time and near real time. "Suffice it to say, they have differences," he says, noting that it can range from a few seconds to minutes.
Kovelsky warns firms not to get seduced by real-time issues. "You don't need everything in real time," he says. As long as the processing is done "seamlessly" something can take a half-day; "It's OK, it doesn't need to be done in real time."