If the securities business were a house — a big, glitzy, many-roomed mansion of a house — then securities clearing would be its electrical system. Throw a light switch or hit “start” on the microwave and the appliances come to life. You don't think how or why. They just work. Same with clearing. When a rep authorizes a trade, it's assumed that it will settle efficiently and accurately, but with the firm providing the clearing service remaining as low-profile as your electric company.

But that relative anonymity might soon be a thing of the past. Consolidation in the clearing business has given rise to a class of utility-like companies bent on expanding their service offerings well beyond basic clearing. With the additional services — allowing a client with a concentrated stock position to borrow against it to enhance his liquidity, for instance — clearing firms are likely to cut a higher profile in the life of financial advisors. For this reason, understanding the clearing business takes on new importance.

The correspondent clearing business started as a way for broker/dealers with excess capacity in their back-office clearing operations to reduce expenses by settling trades for other brokers. The fortunes of these firms rose with volumes and with income from record levels of margin debt. But as the bull market roared on, the top clearing customers started to flex their muscles.

“Correspondent brokers used their market power to negotiate with clearing firms and drove their costs down dramatically,” says Rich Lindsay, head of Bear Stearns' Global Clearing. This was good for the broker, but hard on the clearing firms — particularly when the market took its subsequent dive and volumes dipped. The new economics of clearing drove many of the marginal providers out of business.

The survivors understand the need to add transaction volume while also launching new services that can make up for the commodity-pricing of clearing services. For many, the first step in achieving this is to acquire complementary firms.

Bank of New York, for instance, made itself the nation's largest clearer with a much publicized $2 billion acquisition of CFSB's Pershing unit. The merger combines BoNY's global reach, extensive custodial services, and broad product platform with Pershing's state-of-the-art technology and substantial retail client base. The two next-largest competitors, Global Clearing and U.S. Clearing, are owned by diversified firms, Bear Stearns and Fleet Services, respectively.

A much smaller firm, Fiserv, has been growing steadily through acquisitions, buying up five rivals in the past five years. The company doubled its institutional revenues with the acquisition of Investec Ernst. Fiserv executives noted that the acquisition was part of a diversification strategy. “We've traditionally been retail-oriented,” says Bob Beriault, president of Fiserv's Securities and Trust Services group in Denver. “With Investec, we're concentrating on more institutional broker/dealers.”

As these companies grow in size and sophistication, they are proving more attractive to broker/dealers. And as the broker/dealer industry undergoes its own consolidation, a rising percentage of firms are opting to outsource clearing operations. According to TowerGroup, a research company based in Needham, Mass., in 1995, 66 percent of the nation's 6,200 broker/dealers outsourced their clearing. By last year, the number of broker/dealers had shrunk to 5,500 and the percentage of outsourcers among them had risen to 76 percent.

There are many good reasons to outsource, the best being the cost of keeping up with the latest technology. Over the last few years, IT budgets have shrunk at annual rates of between five percent and 10 percent, according to TowerGroup. Meanwhile, “the fixed costs of being in this business are increasing every day,” says Jim Crowley, managing director of the Global Customers Group at Pershing. “The industry is changing so fast and regulatory requirements are becoming so great, that the technology investment is less appealing” to in-house processors. By way of example he cited Deutsche's outsourcing of its private client group. In addition to relieving itself of the operational burdens, the broker/dealer acquired the ability to switch from a fixed-cost clearing to a variable-cost model that fluctuates with their business needs.

Adding to the IT bill is something that should interest brokers keenly: the need to diversify their offerings. “The main problem is that clearing has more or less become a commodity,” says Sang Lee, analyst with Boston-based Celent Communications. To compete, providers have to provide brokers with good front-end desktop technology, which is expensive to maintain and to deploy. According to TowerGroup, clearing firms will increase spending on their workstation technology from $458 million in 2002 to $561 million in 2005.

Peter Benzie, executive vice-president for Fidelity's correspondent clearing business, summarizes the shift in priorities thus: “We moved from a business that was 80 percent focused on the back-office clearing of trades and posting of dividends and sending out statements to a much broader business. Now, it's all about platforms, technology and service.”

Of course these added services carry fees, but they also eliminate much of the patchwork systems that brokers used to have to cobble together. Now it's relatively easy to find a service provider with a full line of products — from contact management to risk management.

Most clearing companies now offer basic workstations that reps can use to view accounts, place trades, and get research, and some offer real-time news and market data. The new systems have significantly streamlined many of the most basic processes, including opening a new account. “The rep can sit at a workstation and ask all the pertinent questions about income and resources and goals, and then hit send,” says Benzie. “That information will then be compared with a predetermined set of standards and will either be approved, reviewed, or immediately kicked out.”

Client or financial data can be parsed any way the broker wants. “Traditionally we would generate a set of reports and produce paper copies that someone in the back office would run over to the client…It didn't always meet their needs,” says Global Clearing's Lindsay. The firm's report writer allows reps to easily select how they want to view and aggregate this data themselves. “If you want a report that puts commissions and zip codes together or tracks the performance of certain registered reps and the differences in entitlements from one branch to another, you can get it yourself without any paperwork or confusion.”

Increasingly, it's necessary to offer cash management programs, complete with credit cards and check writing. In addition, brokers need to allow their clients to view their accounts online as well as to trade and to transfer funds easily among them.

“The business has shifted from a demand for low-cost solutions to more complete end-to-end solutions,” says John Bahnken, president of U.S. Clearing, a division of FleetBoston Securities Inc. “Asset management accounts have become a cornerstone of all broker-dealer product offerings.” U.S. clearings latest product, E Documents, is a virtual filing cabinet that stores, for up to seven years, most documentation sent by brokerage firms to their clients, from confirmations and statements to 1099s, proxies and prospectuses.

Rules-based risk management systems, which have taken on more importance since September 11, automatically apply rules to certain transactions. If a broker or a client is attempting a trade that violates one of the rules, the system alerts a compliance officer.

Leading clearing firms also are reaching out to RIAs, with products such as mutual-fund wrap accounts, separately managed accounts and programs that handle the administration of retirement plans. “There's a growing trend for broker/dealers to get reps to do more fee-based business,” says Fiserv's Beriault. Thus far, the vast majority of the RIA business goes to money management firms like Schwab, Fidelity, and TD Waterhouse. But correspondent-clearing firms that usually deal with broker/dealers could in time make a dent in that business. For one thing RIAs don't like the fact that Schwab and Fidelity have in-house advisors who compete with them.

But there's still plenty of commission business left, and some registered investment advisors are even going the other way, letting broker/dealers do it, says Global Clearing's Lindsay. “It's a matter of firms finding the right product mix.” His firm offers software that allows RIAs to bill and allocate fees across different products for different types of accounts.

Clearing firms are also going for the gold by chasing RIAs with high-net-worth clients using specialized products. Bear Stearns, for instance, is actively seeking clients with $200 million or more under management. “We may have clients with an end customer who founded a company, has $200 million tied up in a single stock, and wants to realize some of that money without selling the stock,” says Lindsay. “A little broker/dealer who has this client and part of their account doesn't have a derivatives department but we can provide them with that facility so they can compete head on with a wirehouse like Merrill Lynch.”

Southwest Securities, a small Dallas-based firm, is creating a whole new platform to deal directly with RIAs. “It appeals to a lot of advisors working at major wirehouses who may be fed up,” says Lana Giaudrone, vice president of clearing company services at Southwest.

As the consolidation continues, the range of services that clearing firms offer brokers is only going to expand. And though the diversification of products and services might make it harder to distinguish between clearing companies, banks and brokerage houses, it is only going to benefit the end users — you and, ultimately, your clients.