Registered Rep.: What are the biggest hurdles that clearing and custody firms will face in the coming year?
Dennis Gallant: Competition for clients. It's still a scale business, and it is highly competitive — the demands on the marketplace are pretty intense from a compliance standpoint, and in terms of technology enhancements. The marketplace is going through a lot of transitions. You've got b/ds grappling with compliance issues, recruitment, advisor retention, the margin squeeze, streamlining performance, and, when all these things come together, that pressure often gets transferred to the custody and clearing firms. B/ds and RIAs are saying, “What can you do for me to make me more competitive, better positioned, more profitable, to reduce my fees, to make it more attractive for us to retain reps, and for us to improve our own revenue?” So, it's a slippery slope. It's not a vendor-type relationship anymore; it's really become a partnership-type arrangement, and they have really become more integrated into the b/d's or RIA's practices. The hard part of this deeper relationship is that it is tough. What are clearing firms and custodians now? They're marketing firms, technology firms, and all these things beyond just custody and clearing.
RR: Why are there so few custody and clearing firms out there?
DG: This is a business of scale. So, throughout the years, there has been consolidation in the marketplace. The clearing business went through a lot of consolidation over the last decade, and now you're seeing it in the custody business as well. It is not an easy business to be in — you need to have the right infrastructure, scale and momentum. But, more importantly, you need to have that reputation in the business. No one is going to hook up with a first-year custody firm in the industry. Furthermore, changing custodians is onerous at best. No one wants to change his clearing firms unless he really has to.
RR: Why are the barriers to entry in this business so high?
DG: I think the barriers are so high because firms can't just offer clearing and custody. They have to offer tech solutions, marketing, consulting capabilities and advisory platforms — they're being more comprehensive solution providers. They also have to be big, broad, and have the reputation and longevity in the industry.
At some point do firms start to dilute their marketing efforts if there are three or four custodians? It's a hard business to be in, even for Fidelity and Schwab to obtain market share, and then when you start adding more and more firms, it gets exponentially more difficult. I think the competitive nature of that marketplace might limit the number of players — otherwise everyone ends up with a smaller piece of the pie.
RR: How does the fact that so many b/ds and RIAs use multiple custodians and clearing firms impact the way the business works and how the firms compete?
DG: For RIAs there are a couple of reasons why they're using multiple custodians. One is that the clients may actually have relationships with other custodians. If a client already has a Schwab relationship, and all the advisor's money is at Fidelity, it may not make sense to be disruptive and move the assets over to Fidelity: There may be tax consequences, and the client may not be very happy. The other reason is that RIAs don't want to put all their eggs in one basket. They might have started off with one custodian, but the pricing and futures of another custodian is very enticing, so they start building a new relationship. Then there is the fiduciary mindset that firms need to have the best execution. For a lot of advisors they look at the marketplace and think, “I like the idea of having the leverage of multiple relationships because I can play one firm off the other from a pricing standpoint.”
RR: Why did LPL go self-clearing, and will other b/ds follow?
DG: It has been quite awhile since LPL went self-clearing [at the beginning of the decade]. It is not always dependent on size — though size does play a factor — because when you get to a certain size you can start justifying some of the costs. It is also based on the business model. LPL went self-clearing because it wanted differentiation, more control; management wanted to create some technology advancements and make things a little bit more proprietary; they didn't want to share it with anyone else. I know a couple of firms such as HSBC and Key Bank that were self-clearing, and left self-clearing — for a lot of firms it goes back and forth. For some firms it depends on the model. It might make sense, and if they can make the economics work and if it is something they need for their business model, then self-clearing at a small firm may make sense. But it's hard to be all things to all people, so even if firms are self-clearing there are still elements that they may need to leverage at a custody and clearing firm. You'll see that outsourcing tends to be increasing rather than decreasing. I am not saying that everyone is going away from self-clearing towards clearing firms, but firms are starting to outsource more capabilities. Many people in asset management say, “I am going to focus on managing assets, and farm out some of the back office I used to do; I don't need to be involved in that.” They're picking and choosing what they're outsourcing.
RR: Do the custody and clearing firms charge fees for any of the extra consulting and other “services” provided to RIAs and b/ds, aside from the basic services? What are these fees like? Are fees for the basic services falling?
DG: From my understanding they're really not. They're adding these services as a value-added service, and they're bundling it into the fees of just doing business with these firms because they don't want to look as if they're nickel-and-diming. They all want to show their value added, and many of these services they're offering are fairly new — so if they're charging firms you might get resistance from b/ds wanting to try it. However, beyond just the charging of these other services, custody and clearing firms have got to be feeling the pressure from fees. Advisors are pushing back on their home offices regarding fees, and putting pressure on fees; then, in turn, the same thing is happening to clearing firms, custodians and any third party working with the brokerage firm. Everyone is going back and saying, “Okay, times are getting tough. How are you going to help me with the economics here?” I think fee pressure on the business is pretty high across the board.