Choosing a Clearing Broker

One of the most important decisions for an upstart broker-dealer (that provides execution services) is with which clearing firm to partner. Whereas the executing, or introducing, broker is hired by the customer and makes decisions about how to trade securities on the customer’s behalf, the clearing firm performs critical back office duties to ensure that the transaction completes smoothly and successfully.

Between the five of us at Proof, we have over 50 years of experience working in institutional equity trading, primarily designing and building trading algorithms and technology platforms at the broker-dealer and stock exchange layers of the ecosystem. But even though we have so much collective experience deep in the weeds of the stock trading world, we still find the topic of clearing and settlement murky and confusing. The mechanics of how securities actually change hands are complicated, nuanced, and archaic.

With that in mind, we’d like to share our experience evaluating and selecting our clearing partner. As usual, this post reflects our experience building an institutional US equities broker, although many of the clearing firms we evaluated also serve retail brokers and clear other asset classes, so some of this information may carry over.

How U.S. Equities Clear and Settle

Suppose an investor wants to own a particular publicly traded stock. The investor hires a broker to go out into the market and purchase it, and the broker does so by sending buy orders to exchanges, dark pools, or even directly to market makers who might take the other side of the trade. But mechanically, once the stock is “acquired,” how does it actually wind up in the investor’s hands?

Tracking stock ownership used to be a very manual process tied to actual possession of physical stock certificates, but nowadays the process is almost entirely electronic. At the center of everything is the DTCC, a private corporation which contains many subsidiaries including the DTC, the central depository where nearly all shares of public stock are held, and the NSCC, the central clearing authority that settles nearly all transactions in public stocks. The DTCC is owned by a large consortium of financial institutions, and it operates as an industry utility, much like FINRA.

The DTC holds possession of physical certificates for just about every share of stock in every company, and those shares are all made out to “Cede & Company,” which is a separate legal entity, but basically part of the DTC. The DTC also maintains a centralized electronic ledger of the beneficial owners (or more specifically, of their custodians) for each share of stock. Technically it is possible to purchase stock and either have the physical certificate registered in your own name or have the issuer/transfer agent record you as the direct security holder, but these scenarios are both very rare. In almost all cases, the stock is registered to Cede & Co., and the DTC maintains the centralized ledger showing the total balance of shares held by your custodian (typically your broker), who in turn maintains a ledger of the holdings of each of its customers, including you.

The other major piece of the puzzle is the NSCC, which reconciles and batches all individual trades via a process called continuous net settlement (CNS). Instead of each transaction being settled individually, the NSCC acts as a central counterparty to all trades, nets them out against each other, and tells each participant its daily change. As a result, each custodian has just a single in-flow or out-flow each day for each stock that was traded. If everything matches up, the NSCC delivers or pulls funds from the custodians via the Federal Reserve, and the DTC accordingly updates the record of ownership for the securities.

So the example above is actually a bit more complicated:

1. An investor wants to buy a stock.
2. The investor’s executing broker goes out into the market to one or many execution venues (e.g. exchanges, dark pools, market makers, etc.) and purchases the stock. The executing broker reports the terms of each individual execution to its clearing firm as well as to the investor.
3. The clearing firm is also a broker (and a clearing member of the NSCC), and reports the trade to the NSCC including the terms of each execution, the execution venue, and the end investor’s custodian.
4. The execution venue also reports the trade to the NSCC (possibly through a separate clearing firm in the case of a dark pool or a market maker).
5. Vice versa for the counterparty to the trade.
6. The NSCC matches up all of the information from the clearing firms of both parties as well as the execution venue.
7. If the trade information doesn’t all match up, the clearing firms, the execution venue, and the executing brokers need to sort out why the trade is “broken.”
8. If and when everything lines up properly, this trade is incorporated into the continuous net settlement process, and the NSCC coordinates the transfer of funds (via the Federal Reserve) and securities (via the DTC) between all the custodians on the settlement day, two business days after the trade was executed (i.e. T+2).

Note that any or all of the parties above (other the DTCC) can be the same firm. Pretty much all bulge bracket banks have investment arms and proprietary trading desks, as well as broker-dealer arms that provide both execution and clearing services and that operate one or multiple dark pools. So, for example, it’s possible for Goldman Sachs to purchase a stock on behalf of a customer in the Goldman Sachs dark pool, Sigma-X, where the seller happens to be a proprietary trading desk at Goldman Sachs, and both sides are cleared by and custodied at Goldman Sachs as well. It’s easy to imagine how there are both potential efficiencies and potential conflicts of interest introduced by a single financial institution performing multiple different functions in the trading life cycle. In our case, however, all of these parties will generally be completely separate, and Proof Services, our broker-dealer subsidiary, will just be the executing broker in the equation.

Services Provided by a Clearing Firm

Alright, so the clearing firm will be Proof Services’ conduit to the DTCC and will play a critical role in ensuring that all of the client trades we execute go smoothly, but there are actually many different types of clearing arrangements depending on the specific parties involved and who is carrying risk, even just in the US stock market. Additionally, the clearing broker often provides additional services beyond just clearing. Next, we’ll dive deeper into the specific clearing nuances in the US stock market.

Types of Clearing Arrangements

Delivery/Receipt Versus Payment (DVP/RVP) — this is the basic arrangement described above where trades are settled on a T+2 basis. The introducing broker reports each trade to the clearing firm who then reconciles these reports with the NSCC. On the settlement date, the NSCC will coordinate the delivery or receipt of stock in exchange for payment to the custodian of the end investor. The introducing broker is responsible for the trade being properly executed, but technically the NSCC carries the ultimate risk if the end investor’s custodian fails to deliver payment or securities. Because there is settlement risk involved, the NSCC may require the clearing firm to post capital as collateral.

Same Day/Auto Affirmation — in a DVP/RVP arrangement, the custodian for the end investor can provide same day affirmation to the NSCC that the trade is legitimate and that the investor is solvent. If this happens, the custodian takes responsibility for the trade, and the clearing firm is no longer on the hook.

Fully Disclosed vs. Omnibus — the introducing broker may disclose the identity of its customers to the clearing broker, in which case the clearing broker can deal directly with the end investor’s custodian. Alternatively, the introducing broker can choose to keep its customers’ identities anonymous and manage customer allocations itself, in which case the clearing broker will clear and settle all executions into a single omnibus account where all of the end customers’ funds and securities are commingled. A retail broker, for example, might use an omnibus arrangement because it has many small customers such that it might be unwieldy to maintain separate accounts.

Correspondent Clearing (9A/9B) — if the introducing broker executes trades on behalf of another broker-dealer, the two firms can enter into a correspondent relationship via a Qualified Special Representative agreement (QSR). In this scenario, because the end party is a broker itself, the introducing broker’s clearing firm does not need to assume risk as it reports the trade to the NSCC on behalf of the end broker’s clearing firm. Alternative Trading Systems such as dark pools are a common use case for this type of arrangement.

Self Clearing — the vast majority of large brokers self-clear their trades. That is, both the execution and clearing of trades are done by the same firm. I don’t have a solid grasp on what exactly it takes to become self clearing, but my impression is that it is both very capital intensive and operationally complex. Robinhood, for example, switched from clearing through Apex to self-clearing a little over a year ago, and that seems like it was a massive undertaking. Maybe we’ll seriously consider self clearing one day, but for now we’re kicking that can down the road.

Our Situation

Proof Services will have a fully disclosed DVP/RVP clearing arrangement, and hopefully our customers’ custodians/prime brokers will be able to support auto affirmation (otherwise, any financing charges resulting from NSCC capital calls will need to be passed through all the way to the end investor).

Custody, Margin, and Stock Loan

Clearing is often bundled with other services such as custody, stock loan, and margin financing as part of a prime brokerage arrangement. A retail broker or proprietary trading firm, for example, might have the need for a prime broker that provides all of these services together.

In our case, because Proof Services will be dealing exclusively with institutional investors who prime elsewhere (i.e. they have a pre-existing prime brokerage relationship), the clearing broker generally will not serve as the custodian on executed trades, and it will only maintain an error account on Proof Services’ behalf.

Execution Services

Finally, the clearing broker can even provide execution services to the introducing broker such as direct market access (DMA), connections to wholesalers, or even a suite of execution algorithms.

For example, a retail broker might direct orders to wholesalers through its clearing firm, or a relationship-driven institutional broker might white label its clearing firm’s algos.

Proof Services may wind up utilizing another broker for DMA, but the trading algorithms themselves are the core value proposition so those will be built in-house.

Identifying Potential Clearing Firms

Next up: how do you actually find a potential clearing partner? When we started this process, it wasn’t obvious to us which firms are the major players in the space and which were the best potential partners for us. Pretty much every major broker self-clears its trades, and there aren’t very many upstart broker-dealers, so finding a clearing partner for your new business isn’t too common a problem. We’re actually pretty unique in that this is our second firm going through this experience, although none of us were directly involved in selecting the clearing partner at IEX.

Using the NSCC Member Directory

One friend suggested with take a look at the NSCC member directory. The NSCC publishes a directory of active clearing firms as well as which clearing firm is utilized by each broker, by MPID. You can lookup another similar firm, for example, and see which firm they use for clearing. IEX (MPID: IEXG) for example uses clearing firm 0161, which is Bank of America (formerly Merrill Lynch Broadcort).

One thought is to simply count how many MPIDs trade through each clearing firm to get a crude sense of which ones are the most prolific, and potentially the most likely to be willing to work with a startup. Here are the top 15 clearing firms by # of MPIDs that clear through them:

*Note: ETC was recently acquired by PEAK6 (the parent company of Apex) and rebranded to Apex Pro.

Even though this is not how we began our search, we actually did wind up having at least one conversation with almost all of these firms. For our process, we simply started with our immediate network and asked folks with relevant experience to make introductions that they thought would be productive. Even in cases where the firm wasn’t going to be a good fit, they oftentimes offered to make introductions to competitors who might be more suitable partners, which was very helpful. Clearing does seem to be a pretty small and friendly world.

Evaluating Clearing Firms

The wrong choice of clearing firm can lead to unduly operational overhead, create substantial regulatory and/or counterparty risk, or even destroy an upstart broker’s margins if the pricing structure is untenable. We wound up speaking with 12 potential partners and getting to formal proposal stage with four of them. Here are some of the elements that went into our final decision.

Pricing

We encountered a wide range of pricing structures, but there were three main features:

• Charge per parent order ticket
• Charge per individual execution
• Charge per share

Some proposals only had one of these components, whereas others had all three. In some cases, these fees were fixed and simply non-negotiable, whereas other clearing firms were willing to completely scrap or restructure their proposal based on our preferences. We modeled out our projected volumes to make sure that our business is sustainable at scale. It appears that the most common approach is a per-ticket charge, but for our use case a simple per share fee with no ticket or execution charges was the most viable path. Our initial expectations around clearing costs turned out to be reasonable, and any of the four proposals could ultimately have worked for us.

Minimum Revenue

Another major component of the clearing proposals was the minimum revenue they require you to pay, even if you trade zero volume in a month. Some of the firms we spoke with had very high minimum revenue requirements (e.g. in the seven figures), but most of them were pretty reasonable, and many of the firms were willing to start off with a low minimum and scale up over time.

Additionally, some of the firms we spoke with tied their minimum revenue requirements to which services we would consume. For example, they might require a modest minimum monthly revenue if we agree to execute our volume exclusively through their algos, but if we wanted to execute away from them, the minimum would skyrocket.

Minimum Deposit

Every clearing firm we spoke with requires a minimum deposit, in most cases in the range of $100k to $500k. Some firms had much higher baseline requirements on this front, in the millions or even tens of millions. Like the minimum revenue requirement, the minimum deposit was sometimes linked to which services we would utilize through the clearing firm.

Intraday Risk Limits

In order to manage their risk, most clearing firms cap how much volume you can execute per day. For some of the clearing firms, this risk limit is applied on a net basis, so for example for a market making firm that frequently opens and closes positions would probably be just fine. These risk limits were generally a multiple of the clearing deposit, so for example as we scale up, we may need to deposit more than the minimum to ensure we always remain within the risk limit.

Consultancy and Other Services

As mentioned above, many of the clearing firms also offer other services like stock loan and execution algos. Additionally, many have a great deal of experience navigating the regulatory environment and seemed like they could be an excellent resource to consult with when designing features of our trading system such as our exception reports and 15c3–5 risk checks.

Due Diligence

In addition to the numbers in the proposals and the impression we got during the sales process, we also solicited feedback from folks in our network who had dealt with each firm, either as prospective or actual customers, or as counterparties. We also examined their regulatory track records, including any disciplinary actions, which are available on FINRA’s BrokerCheck website.

Where We Landed

From start to finish, this process of selecting a clearing firm took roughly 10 months, although it really only ramped up during the proposal/negotiation period with the final four contenders over the last six weeks or so. Ultimately, we selected Apex Pro (formerly ETC), and we’re very excited to be partnering with them. They were outstanding to deal with during our evaluation process, which we do think reflects well on how it’ll be to work with them once we’re up and running, and the references we got from our network were stellar. Our only holdup was that their disciplinary record isn’t perfectly clean, but it’s not too bad. Plus with their recent acquisition by PEAK6, we feel good about their long term financial prospects. Overall, we’re thrilled to have this decision behind us, and we’re very hopeful this is the beginning of a long and prosperous business relationship!