Overcoming the challenges to growth for broker-dealers

Transcription

1 Overcoming the challenges to growth for broker-dealers The months ahead will be a challenging time for the financial services sector, and broker-dealers face significant uncertainty. A broad spectrum of regulations will be drafted, proposed, finalized and/or newly enforced before the end of 2012, while the economy struggles to maintain and increase positive momentum. Growth opportunities for broker-dealers may be hard to come by in this environment, but there are some key steps to take now that could give firms an advantage over their competitors as the regulatory and economic picture becomes clearer. Broker-dealers that maintain a strong focus in five key areas have an opportunity to improve their position in the marketplace in spite of the current conditions. Those areas are revenue growth, regulatory response, risk management, technology and operational effectiveness. Revenue growth While markets started to recover at the end of 2011 and have shown strength in the early part of 2012, continued uncertainty could push markets and trading volume back to earlier, lower levels. Firms should continue to explore alternative revenue sources to balance out variances in market trading activities. They need to be more proficient in dealing with regulations and providing value to customers. Revenue growth will come through developing creative products and the innovative use of existing market processing. Brokerdealers should assess their strategies to maintain and grow revenue. For many firms, the best approach will be to leverage or grow their existing lines of service. They should evaluate options for providing additional services from their existing platforms, increasing volume in markets currently served, and exploring new markets. Broker-dealers should ensure that they provide the full range of services permitted under their licenses. For instance, those that work with qualified investors might seek to expand the work they do with unregistered public offerings. Firms will also need to comply with the regulatory implications in this area. In fact, some Financial Industry Regulatory Authority (FINRA) standards have changes that go into effect this year. For more on these standards, see Grant Thornton s Financial Bulletin, SEC adopts new net worth standard for accredited investors under Dodd-Frank Act, Dec. 22, Broker-dealers can help clients with active trading profiles that might benefit from direct market access through trading systems. Professionals who provide this service need to institute control procedures that manage regulatory concerns and protect against fat finger trading errors. Broker-dealers also need to make sure they comply with new rules requiring identification of large traders. With the right processes in place, this service can provide additional value for clients without significant additional costs to the practice.

2 Broker-dealers serving institutional clients should focus on enhancing services such as prime brokerage, direct market access, securities lending and other allowable services. Institutional clients with an inventory of available stocks can capitalize on securities lending programs. However, the risks related to making securities available for covering the shorts used for securities lending should be adequately explained to clients. For example, such securities are no longer protected under the Securities Investor Protection Corporation, and the ability to engage in corporate actions may be limited. Advanced notification of these risks helps clients to decide if they want to be involved with this type of trade and to determine the level of potential return that would justify accepting the risk. Many firms are already looking to assist retail clients interested in additional asset management services. Consultations on stock purchases, advice on maintaining portfolio balances, and ongoing investment management can flow naturally from the work that most broker-dealers do. High-networth clients can benefit from managed accounts, wrap accounts and highend investment services. Accredited investors can participate in alternative asset services, although broker-dealers must ensure they are steering clients into appropriate investments. Firms that look to expand services in this direction should be aware that the upcoming combination of the know your customer rules with the suitability rules requires additional documentation of the customer s profile. All of these services can be additional growth opportunities once retail clients rely on a broker-dealer to execute trades, it s not hard to build the extra layer of trust that will lead them to seek advice on future investments. Demographic trends can also offer broker-dealers new ways to grow. As the number of defined benefit plans continues to wane and defined contribution plans become the norm, retirement services can be a growth area for firms that successfully leverage their client base. This trend, combined with the large number of baby boomers who are expected to retire in the next decade, will increase demand for retirement planning services. Innovative retirement programs and offerings like targeted date funds, specialized customer services, account aggregation and advisory services for plan management could provide additional revenue for broker-dealers in the future. Other services such as annuities and income-based portfolios offer additional opportunities for revenue growth. Regulatory response Preparing for compliance with upcoming regulations will require a significant investment in time and expense for broker-dealers. But by preparing now for regulatory deadlines, firms can focus on efficiency and cost-effectiveness in their compliance process. Broker-dealers that delay implementation will fall behind the competitors that adjust their systems earlier and will risk penalties if lastminute solutions aren t compliant. And while many rules have yet to be written, firms should understand and begin to address the key provisions and regulatory framework that the Dodd-Frank Wall Street Reform and Consumer Protection Act is putting in place. Broker-dealers can keep themselves ahead of the regulatory curve by implementing a firmwide Dodd-Frank Act program management office (PMO). This office can review the act to determine what provisions will affect the firm and its competitors, and then monitor developments as new rules are created in those areas. This analysis serves two purposes: It can help the firm comply fully with new rules as they are created and, if done properly, it can also identify growth opportunities when new rules limit the ability of competitors to provide certain services or products. The PMO can also identify and coordinate other parts of the organization that will be affected by changing regulations, such as legal, IT, compliance, front office and risk management. Although the sheer volume and scope of regulations can be overwhelming for broker-dealers, firms don t need to overhaul their entire compliance approach. Broker-dealers should focus on the regulations that impact them the most, such as specific provisions of the Dodd- Frank Act including the proposed Volcker rule major changes to the swaps market, and systemic risk reporting, as well as consumer protection, transparency and reporting rules. In addition to the Dodd- Frank Act, several other major regulatory rules are being proposed and implemented. Following are three examples of new rules or regulatory actions on which brokerdealers should focus. Broker-dealers serving institutional clients should focus on enhancing services such as prime brokerage, direct market access, securities lending and other allowable services. 2

3 Large trader reporting: Individuals who trade more than 2 million shares or $20 million in one day, or more than 20 million shares or $200 million in a 30-day period, are now required to obtain a large trader number from the SEC. As of April 30, 2012, broker-dealers will be required to identify potential large traders who were previously unidentified. Such previously unidentified large traders will be reported separately, and the broker-dealer must have procedures in place to monitor such trading activity. FINRA has also announced additional adjustments that will need to be incorporated into traders electronic blue sheets as of Aug. 31, Broker-dealers should begin collecting these numbers from qualifying clients and modifying forms to comply with new requirements. Short sale trading rules: While Regulation SHO is not a new rule, a recent disciplinary action by FINRA highlights that failure to maintain proper controls can have dire consequences. Many of the failures have been related to trading systems that were not thoroughly tested or were serving as a unique silo. In addition to the fines, many transactions originally treated as long sales by the broker-dealer were reclassified as short sales, resulting in inappropriate identification and incorrect determination of threshold securities. Broker-dealers need to review FINRA s action (Letter of Acceptance, Waiver and Consent No ) to ensure that their systems comply with all regulations. Risk management Broker-dealers now function in a regulatory environment that has a keener awareness of and a heightened sensitivity to the risks associated with their activities. The driving force behind many new disclosure requirements is the federal government s desire to manage risk in the U.S. financial system (systemic risk). One key to understanding and complying with these requirements is managing risk within each firm (enterprise risk). Systemic risk The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC). The council s purposes are to identify risks to U.S. financial stability posed by the failure of large financial institutions and to promote market discipline, as well as to identify emerging risks to the U.S. financial system. Customer record transfer rules: December 2011 marked the end of the comment period on FINRA s proposed rules requiring firms to maintain and keep current certain records in a central location. The socalled living will rules are intended to facilitate the transfer of client records in the event of a brokerage house failure. Some have suggested that existing data management processes at brokerage houses provide sufficient information, but the final rules will determine if significant changes need to be made. 3

4 The FSOC is charged with gathering information from a variety of financial institutions and evaluating whether the activities of those institutions pose an undue risk to the financial markets. While many of the reporting requirements that help the FSOC make this determination may be managed by other federal agencies, broker-dealers need to understand that the overarching goals of the government s activity are more effective management of systemic risk and stabilization of U.S. financial markets. Enterprise risk management Given the government s level of interest in managing systemic risk, brokerdealers will be well-served by enhancing their awareness of the enterprise risk within their institutions. Enterprise risk management (ERM) offers an approach to assessing and addressing the full risk profile of the institution, including key strategic risks such as operational, financial, regulatory, credit and market risks. The assessment process allows all parties to fully understand the impact of major new initiatives across the institution and enables clear strategic decision-making. When performed with an eye toward the government s work on systemic risk management, the assessment can provide broker-dealers with insight on the types of activities that they may need to disclose in the future and prepare them to comment on proposed regulations as they are released. In addition to improving a firm s ability to comply with future disclosure requirements, an ERM assessment also delivers a close look at the institution s internal supervision and control framework. Given the damage that a violation of client trust can cause to a financial services business, leaders need to be aware of potential weaknesses in their system and take swift action to institute additional protective processes when necessary. Technology Improvements to software, hardware and IT processes can provide brokerdealers with a competitive advantage. To gain that advantage, firms need to evaluate if the cost and effort associated with implementation will result in an improvement. Examine the strategic plan and determine if the proposed changes would support initiatives described in the document. Look for opportunities to improve systems that can support multiple key initiatives. System upgrades can also deliver information that improves a firm s ability to comply with new regulations. The cost of a new system can be balanced against the potential savings in compliance costs, as well as any new revenues that it might help generate. Cloud computing Cloud computing offers broker-dealers an opportunity to reduce costs, but the strategy involves more risks for financial institutions compared to other industries. Broker-dealers must manage their service provider effectively if they want to implement an off-site system. With less physical infrastructure, firms can save on personnel, facilities, energy and maintenance costs. However, broker-dealers that outsource functions to third parties remain responsible if the third-party s performance fails to meet regulatory standards. Specific risks that financial service providers should consider when evaluating a cloud computing arrangement include the following: Data security and controls Make sure the cloud provider maintains controls that meet or exceed regulatory requirements, and evaluate the risks involved in transmitting data over the Internet. Regulatory compliance Choose a provider that is familiar with industry-specific requirements, legal standards and the laws of any relevant jurisdictions dictating where and how data can be stored. Multitenancy Be aware of the provider s policy related to the segregation of its clients data. 4

5 Location Hosting data in the cloud can create uncertainty as to the physical location of institutional assets. Reliability Cloud computing introduces the risk that data might not be accessible when needed. Sustainability Consider the adequacy of a provider s disaster recovery procedures. Social networking Social media is a powerful communications vehicle with international reach. According to a recent survey conducted by Grant Thornton LLP and the Financial Executives Research Foundation, Social media and its associated risks, more than half (53 percent) of respondents see corporate use of social media increasing significantly over the next 12 months. Yet more than three-quarters (76 percent) of respondent companies do not have a clearly defined social media policy. Broker-dealers face additional hurdles to getting social media right. Due to rules that govern correspondence with customers, broker-dealers are required to maintain records of all customer communications including social media which can be difficult. Industry regulators are heavily scrutinizing the use of social media as emerging technology expands the ways that firms connect with and provide information to clients. Operational effectiveness In addition to growing revenue, managing regulatory changes and risks, and keeping technology current, broker-dealers that want to succeed in this market need to make sure their internal processes are streamlined and effective. Broker-dealers will need to do more with less. With the cost of regulations and a challenging market, firms need to operate efficiently, without sacrificing internal controls and supervision. A strong project management function is critical to successfully implementing these types of operational enhancements. Leaders need to control budgets and timelines, as well as understand the progress that has been made and the work that remains to be done. Teams that implement new systems need to work across functions in the organization, drawing on compliance, IT, operations, finance and client-serving professionals to make sure the new protocols meet regulatory requirements and the needs of the business. Given the quantity and scope of the new rules taking effect in the coming months, broker-dealers should consider the use of outside support to manage costs and enhance operational efficiencies. Outsourcing FINRA produced rules in 2005 that permit broker-dealers to outsource ministerial functions and, under certain conditions, activities and functions related to their business activities. The rules allow broker-dealers to outsource some of their business activities, but they still hold a broker-dealer responsible if the third party s performance fails to meet regulatory requirements. For example, cloud computing is one way that brokerdealers can take advantage of outsourcing their technology. In 2011, FINRA issued proposed rules that would clarify the functions that can be outsourced only to licensed third parties. Broker-dealers need to conduct adequate due diligence of third-party service providers to ensure they are capable of meeting the standards to which brokers are held. Brokers should monitor the implementation of proposed changes to FINRA Rule 3190, because the final rule could cause some firms to reevaluate the functions they have outsourced and the vendors they have engaged for such functions. Teams that implement new systems need to work across functions in the organization, drawing on compliance, IT, operations, finance and client-serving professionals to make sure the new protocols meet regulatory requirements and the needs of the business. 5

6 Constantly develop and implement best practices In addition to finding new ways to serve existing clients, broker-dealers need to ensure that in-house procedures deliver the efficiency and security that clients expect. Broker-dealers should constantly be on the lookout to develop or adopt leading-edge practices through peer exchanges, industry groups, benchmarking and other advisers. Many leading broker-dealers are focusing on best practices in these areas: With FINRA s move away from the Three Quote Rule in December 2011, trade processes should be reviewed to make sure that they reflect the new best execution standard for nonexchange-listed securities. Make sure that client credits earned (soft dollars) are held in segregated accounts to alleviate any concerns clients may have, particularly in the wake of recent broker-dealer bankruptcies. Take time to explain to clients the value they get for the fees they pay. From safeguards like segregated accounts to the advice and support provided throughout the year, make sure clients know that broker-dealers do more than just collect fees for their transactions. Review compensation and benefit policies to stay competitive within the industry. The loss of top-performing staff to competitors can cost brokerdealers dearly. Success in 2012 and beyond By focusing on some of the specific changes expected in the short term, and building systems that can grow revenue and enhance compliance into the future, broker-dealers can position themselves for consistent success in today s financial markets and beyond. Broker-dealers should constantly be on the lookout to develop or adopt leading-edge practices through peer exchanges, industry groups, benchmarking and other advisers. 6

7 Acknowledgements: Special thanks to Rich Flowers, Steven Goldberg and Erin Morrow. About Grant Thornton The people in the independent firms of Grant Thornton International Ltd provide personalized attention and the highest quality service to public and private clients in more than 100 countries. Grant Thornton LLP is the U.S. member firm of Grant Thornton International Ltd, one of the six global audit, tax and advisory organizations. Grant Thornton International Ltd and its member firms are not a worldwide partnership, as each member firm is a separate and distinct legal entity. For more information Jack Katz National Managing Partner Financial Services Grant Thornton LLP T E [email protected] Nichole Jordan National Banking and Securities Industry Leader Grant Thornton LLP T E [email protected] 7

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