For several years, Regal Securities, a Glenview, Ill.-based brokerage firm, handled its clearing in-house. But, then the firm handed off the job of settling trades and other back-office functions to Fiserv. At first it was a relief having a large specialist firm take over the complex custody/clearing operations.

But that changed when Fidelity's National Financial acquired Fiserv, creating a new clearing-house giant, the second largest in the industry (as measured by clients). While the new National Financial offers advantages to many broker/dealers, Regal found itself in an awkward position: It was now outsourcing its custody and clearing business to a unit of a rival (Regal Discount Securities, a discount broker, competes directly with Fidelity's discount brokerage).

Naturally, the other top clearing houses sensed opportunity. All the major players aggressively courted Regal, which has some 50,000 clients. Instead, in October 2005, Regal decided to move its clearing obligations to a relative upstart — Penson Worldwide. One of the main reasons for the move, Regal says, was that Penson was promising to stay focused on custody/clearing operations — and pledged not to offer a wider variety of services that would compete with Regal.

“We do enjoy the fact that Penson is a neutral player,” says Robert Walter, senior vice president of business development for Regal. “They truly are in the business of clearing. A lot of their competitors are looking to compete directly with correspondents.”

That argument is exactly what Dallas-based Penson believes is proving to be a valuable competitive weapon against its larger rivals. Penson promises to keep out of any business that would directly challenge its clients' own products and to stick to a core set of services that includes securities lending, custody/clearing and order-management systems.

“The biggest clearing firms have a lot more offerings for their customers, some of which, directly in many cases, compete with their correspondents' own offerings,” says Penson president and co-founder Daniel Son. “We're staying away from that. Wherever possible our goal is to offer non-conflictive products — very specialized, focused offerings.”

It seems to be working. Penson, which a decade ago had only a dozen or so clients, has become the fourth-largest clearing house in the market, with some 250 clients at of the end of 2006. That puts Penson within striking distance of two larger rivals — Bear Stearns, with 335 clients, and National Financial itself, with 353 clients at the end of last year. And while Penson is still relatively small compared with the custody/clearing market's dominant firm — Pershing/Bank of New York, which had 852 clients at the end of last year — Penson is now a viable challenger to the market's giant.

Penson is not alone in exploiting what it and other smaller players describe as a custody/clearing market dominated by unwieldy goliaths. LPL Financial Services, for example, which left Pershing to begin self-clearing at the beginning of the decade, is now starting to offer clearing services to other firms, including recently taking over back-office clearing for Axa.

“We're going to serve much wider varieties of portfolios,” says Esther Stearns, LPL's chief operating officer. “With this insurance b/d client, we are going to provide them with a complete middle- and back-office system — they will have their own relationships with their employees, but we'll do the rest.”

To be sure, the dominance of giants like Pershing and National Financial is not in danger of waning any time soon. Custody and clearing is such an onerous task for brokerages, especially given new regulatory requirements and increases in both volume and type of transactions to be settled, such as futures and credit derivatives, that the economies of scale offered by a massive clearing operation are too compelling for many brokerages and advisors to deny.

The Texas Maverick

Penson, started by Son, CEO Phil Pendergraft and nine other employees in 1995, acted as a larger-scale firm from its inception, in part because some of its earliest correspondents had heavy daily clearing volumes. These clients included Mt. Pleasant Brokerage, CyberTrader and A.B. Watley, each of which was accounting for at least 10 percent of Penson's revenues in 1999, according to Penson's S-1 statement for 2000. Penson had to learn quickly how to handle massive volumes when it only had a relative handful of employees. (And although Schwab acquired CyberTrader in 2000, it still uses Penson for clearing, while the rest of Schwab is self-clearing.)

Penson soon began to plow its earnings into continually building up systems technology. “Our infrastructure enables us to bear enormous volume. We have handled as much as a million transactions a day and are growing,” Son says. In 2002, Penson acquired Integrated Trading Solutions and invested in Nexa Technologies, both software firms with front-end trade entry software platforms.

At the same time, Penson realized that growing consolidation of power in custody/clearing was generating its share of discontents. The May 2003 acquisition of Pershing by Bank of New York was a critical moment for Penson's growth, as that merger drove some former Pershing or Bank of New York clients to think about alternatives.

So Penson crafted a sales pitch based around low costs and increased flexibility. Son argues that the largest clearing firms often essentially tell clients: “ ‘Here's what we offer, you need to fit your business to this model.’ That is the wrong way around,” he says. “We listen to what our clients' needs are and provide something to get it done their way.” Penson also has a streamlined decision-making process — Son and Pendergraft still share a single office, and tend to sign off on decisions quickly, often dispensing with an intermediary chain of command.

But, however much Penson claims it is a maverick, the fact is that Penson is in some ways much like its rivals — it is now a heavily capitalized, publicly-traded firm that is snatching up companies in order to fatten its client lists and expand its product lines. When Penson went public in May 2006, raising $111 million, the company immediately put the cash to work, making two major purchases in less than a year.

Penson first acquired the clearing business of Schonfeld Securities, which analysts expect will add $15 million in additional annual revenues, and more recently announced it will purchase for $35 million the clearing and customer accounts business of futures trading firm Goldenberg Hehmeyer & Co. The Schonfeld deal was meant to increase transaction volume, while Goldenberg Hehmeyer was a purchase done mainly to plug a hole in Penson's product offerings — Penson will now have a wholly-owned subsidiary that will be able to clear products for various futures exchanges.

Expect to see further acquisitions in the future. “We get a lot of opportunities to talk to lots of companies — I can't be more specific than that,” Son says. “When an acquisition could be accretive to earnings and fills the needs of some product offering gap, or is something that would increase transaction volume, we wouldn't preclude that.”

Going It Alone, Together

Around the time Penson began its steady climb to the top tier of clearinghouse firms, LPL was deciding to go it alone and take its clearing back in-house.

Deciding to leave Pershing was a costly, grueling process. Leon Lee, LPL's managing director of advisor services, says going to self-clearing while running a business is the equivalent of living in a house while it is being built. It took about two years for LPL to fully take over its clearing operations, and the firm says it was lucky to find the necessary personnel: The Banc of America/Nationsbank merger in the late 1990s resulted in BofA closing down a San Diego brokerage operations office and relocating it to North Carolina, which in turn opened up a pool of employees for LPL to lure away.

Why leave Pershing? LPL says it found it was still doing a lot of work on the clearing end even though it had officially outsourced the work to the largest clearing firm in the market. “Over time you tend to supplement the service. It's a natural desire that everyone has to control services that they deliver to their own customers,” LPL's Stearns says. “But you end up with a lot of duplication of expenses.”

LPL, which runs clearing services for all of its advisors, is now taking its clearing business outside, looking to offer prospective clients an alternative to the industry giants. It has a growing list of new clients, including banks, credit unions and even insurance companies, and is expanding to cover a wider range of product clearing, including variable annuities settlements. “Our primary objective was always to clear for our advisors and, therefore, develop products and services on that basis,” Stearns says. For example, LPL slowly put into place a document-management system which, over time, has led to advisor clients being able to access all clearing/custody-related paperwork online, linked directly to their client accounts.

Self-clearing has also helped LPL reduce costs to its advisors and offer new incentives. For example, LPL increased its advisor production bonuses to a 98 percent payout, up from a cap of 92 percent in the past. “All of that relates to the economies we've put in place,” Stearns says. LPL also has credited self-clearing with helping it to eliminate the $5 charge it once imposed for monthly mutual fund withdrawals and to lower ticket charges for automated equity trades, among other improvements.

“It really creates efficiencies,” she adds. “At the end of the day [clearing] is not that creative a field. Execution is king in this business.”

While LPL has no illusions about challenging the clearinghouse giants, if the firm inspires more advisors to consider taking clearing in-house, it does present a competitive threat. Ironically, it may most threaten upstart firms like Penson, which are looking to gain market share by convincing firms like LPL to outsource their clearing. Sometimes the argument works. In the late 1990s, when Penson was just getting under way, one of its earliest clients, a daytrading firm, decided to leave and go self-clearing. “Then they found out what we had told them when they left: It's not quite as easy as it seems,” Son recalls. Eventually, the client returned to Penson.

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U.S. Clearing Firms ranked by number of clients.
Rank Firm Number of Clients
1 Pershing/BNY Clearing Services 852
2 National Financial Services (Fidelity Investments) 353
3 Bear Stearns Securities Corp. Global Clearing Services 335
4 Penson Financial Services Inc. 250
5 Southwest Securities 219
6 Goldman Sachs Execution & Clearing 193
7 First Clearing, Wachovia Securities 148
8 RBC Dain Correspondent Services 138
9 Broadcort (Merrill Lynch & Co.) 118
10 ADP Clearing 100
11 Wedbush Morgan Securities 92
12 Sterne Agee & Leach Capital Markets 86
13 First Southwest Co. 78
14 Mesirow Financial Holdings Inc. 75
15 Neuberger Berman 70
16 North American Clearing 60
17 Emmet A. Larkin Co. 55
17 Legent Clearing 55
19 Jefferies & Co. 53
20 Raymond James & Associates 42
Source: TowerGroup