Should an introducing broker dealer become a clearing broker dealer? What you need to consider

There are several factors that need to be considered should an Introducing Broker Dealer (IBD) want to become a Clearing Broker Dealer (CBD). An IBD, otherwise known as an introducing firm, will accept a client’s order for a buy or sell. However, it will have an arrangement with a clearing broker dealer, also known as a clearing firm, that will execute the order and maintain custody of a client’s securities and other assets.

Traditionally, an IBD is client-facing, and acts as an agent on behalf of individuals or entities seeking access to markets with a willing counterparty, a CBD. As a result of this relationship, an IBD has a much simpler business model, with revenue most commonly earned by commissions/rebates on trades executed for referred clients. They also have far less responsibility with respect to customer reporting obligations and data maintenance, as these are predominantly managed by the respective CBD.

While some responsibilities are consistent between both types of broker dealers, as CBDs handle the buy and sell orders as well as maintaining custody of client owned securities and other assets, they typically have a much more onerous back-office function, that can be quite labor intensive depending on its size and the types of securities in which it clears. These duties can include the following:

• Clearing trades
• Sending trade confirmations
• Settlement and reporting compliance
• Trade execution
• Custody of customer funds and securities'

Costs of clearing functions

To facilitate the previous functions, a certain level of infrastructure needs to be in place. If an IBD was to perform these functions without any outsourcing, major areas to consider would be:

• Large, qualified workforce
• Specialized software and CRM systems
• Additional regulatory compliance (SEC, FINRA and SOC compliance)
• Working capital requirements

A significant portion of CBD’s operating expenses are personnel costs related to back-office functions and their associated compliance requisites. Technological development, cybersecurity and data privacy are at the forefront of both client and regulator interests, and a substantial investment is required to develop and implement. A high degree of on-going monitoring and a comprehensive understanding of the flow of data between internal and related external systems is necessary to continually adapt to these needs, conform with regulatory expectations and remain competitive. Additionally, as CBDs have custody over client assets, they must maintain high levels of net capital to be able to segregate the client funds and securities in their custody.

Benefits of clearing functions

It’s possible for an IBD to become a self-clearing firm, where brokers are able to settle their own trades, as well as complete the clearing process internally. While this is only available to firms that have sufficient resources (as previously noted), it provides two major benefits to both the company and its clients, such as:

• Control: If a firm was able to execute and clear its own trades, it gives them the ability to identify any issues and correct them in a timelier manner. By being able to execute their own trades, this will significantly reduce, or in some cases eliminate commissions/rebates paid to third parties, resulting in improved margins on the spread of trades.
• Efficiency: A self-clearing firm allows there to be more centralized communication channels. If issues with respect to trades or the clearing of monies occur, a client would be able to refer all questions to a single location and would be able to receive timelier responses as the firm would be privy to all aspects of transactions.

Reporting requirements

Regulatory reporting requirements are very similar for both types of broker dealers. However, due to the complexity associated with CBDs, these reporting obligations are more costly. The time required to populate the necessary data is significantly higher, both internally and externally. These reporting requirements are expected to be filed within 60 days of their fiscal year-end and include the following:

• Financial report
• Compliance or exemption report (a compliance report must be submitted if the firm did not claim it was exempt from the Exchange Act Rule 15c-3, where an exemption report must be submitted if the firm claimed it was exempt through the fiscal year)
• Securities Investor Protection Corporation (SIPC) filing
• Independent auditor reports

One key difference in the requirements is related to Exchange Act Rule 15c-3, where an IBD will be required to submit an exemption report (in most cases), while a CBD will be required to submit a compliance report.

An IBD has a relatively simple business model, where revenues are directly correlated to client referrals, which if executed properly, will result in a highly profitable business with minimal obligations in respect of reporting. However, becoming a CBD can significantly increase revenue but with a substantial increase in reporting obligations, costs and regulatory compliance. For these reasons, the factors outlined above should be taken into consideration before undertaking a transition.