All clearing relationships are memorialized by a contract which includes addendums outlining other parts of the relationship and a “Schedule A,” which covers the entirety of the costs: broker-dealer and client, unbundled charges, platform fees, and revenue sharing. Some clearing firms have ownership of other vendors (e.g., aggregation, financial planning, or CRM) that can be bundled or unbundled into separate cost structures.
The basic component cost of a clearing contract is the ticket charge, which gets the most amount of attention. It usually is product-oriented (equity vs. mutual fund vs. fixed income) and could have additional surcharge or execution costs. Most importantly, the ticket charge has significantly decreased over the last decade as scale and automation have driven down a clearing firm’s cost to process.
Other cost structures are appearing in Schedule A pricing that did not exist historically. As business is migrating to the advisory space, in many cases ticket charges have been replaced by basis points calculated on (advisory) assets under management (AUM). Basis points can be an attractive pricing alternative because it removes the variable cost risk of ticket charges when an account is incepted or rebalanced. The basis points structure for clearing and custody expense aligns more closely with the traditional advisory fee structure charges by advisors. Also, many clearing firms will bundle other costs into the basis point structure besides execution and clearance, including performance reports and fee billing. The choice of a ticket charge or basis point cost structure is driven by the number trades generated in an advisory model; if you generate many trades, a basis point structure might be better than ticket charges. Some firms like to customize their portfolio management offering, which might include an overlay or the ability to pick out the vendor pieces where control is the most important element. Either way, it’s fairly straightforward to determine the costs of maintaining control vs. outsourcing to a more bundled offering.
Besides transactional charges, whether in the form of a ticket charge or basis points, most Schedule As include other charges that are direct to the firm or to the customer, some of which can be marked up. Attention should be spent on all of these ancillary charges, as they do add up and can have considerable impact on your bottom line.
Revenue sharing is a mainstay of clearing arrangements. Margin Interest, mark-ups, and stock loan are typical opportunities for a firm to add revenue. The most important, however, is cash sweep account funds, which are either money markets or FDIC insured products. Clearing firms typically share the revenue from these assets but it has been nearly non-existent for the last few years (see our previous blog, “The Great Compression”).
Based on recent signals from the Federal Reserve, interest rates have started to rise in 2022. If you’re a broker-dealer this sounds like long-awaited good news. The revenue share that most broker-dealers receive from sweep account revenues in the past have made a meaningful difference in firm profitability. Should we assume the same for the future? This may not be the case.
Regulators on both the broker-dealer and investment advisory sides of the business have begun to question this type of revenue sharing. Disclosure may not be enough as client net yield vs. revenue sharing will be right in the crosshairs of the regulators.
If your clearing contract is expiring and its time to evaluate your alternatives, you should, first, determine what your firm’s intermediate strategy (next 5 years) is; be aware of the marketplace and pricing strategies that fit your business; assume new regulations will impact your profits; and construct as much flexibility in your contract to allow you to pivot as market conditions and regulations dictate.
Oyster Consulting’s experts use their industry experience knowledge gained by working with a wide variety of clients and their clearing or custodial relationships to provide you with targeted, cost-saving solutions. Our consultants stay current with major clearing and custodial firms, their service offerings and representative clients. We use that knowledge to help you review your current contract, ensure business alignment and offer a comprehensive strategy to make sure you get optimal value.