071558 01 BRO NFDirWP -...
Transcript of 071558 01 BRO NFDirWP -...
DIRECT MUTUAL FUND BUSINESS
MOV ING TO AN EFFICIENT FRONTIER
EXECUTIVE SUMMARY
In late 2006, 14 broker/dealer clients shared some observations with National
Financial about the implications of allowing trading of mutual funds directly.1 From
these conversations, we were able to identify some of their best practices for direct
processing of mutual fund business, after learning about the diffi culties of managing
in an increasingly complex environment, and hearing their perspectives about how
the industry ended up in this situation. This paper summarizes the current state
of the mutual fund direct business, the tradeoffs and the costs. We will make
recommendations for how broker/dealers may want to address an optimal approach
to managing their mutual fund direct business — and how to fi nd their point on
an effi cient frontier of direct trading practices.
Industry Estimates
From a recent survey by the National Association of Securities Dealers (NASD)
of member fi rms, it is estimated that some $3.2 trillion assets are held directly
at mutual fund companies:2
n In 2005 there was $8 trillion in mutual fund assets held by U.S. individuals.3
n More than 80 percent owned shares purchased through fi nancial advisers.4
n Firms indicated that 52% of mutual fund purchases are still affected via
“check and app” processing.2
Mutual Fund Direct Trading Situation
The industry fi nds itself in an increasingly complex situation when trading mutual
funds directly. There are many reasons for how we arrived at the current situation.
During the discussion with broker/dealers, three main topics came up each time:
the increased complexity of processing direct; the path of how the fi rms got here;
and the concern that it was getting costly to trade directly.
INCREASED COMPLEXITY
What began as a simple, streamlined, “check and app” process for expanding into
the mutual funds business has become a very complex process. It is fraught with
layers of review, regulatory scrutiny, and signifi cant resources required at the home
offi ce to stay current.
CONTENTS
EXECUTIVE
SUMMARY ................ 1
SURVEY
BACKGROUND ......... 3
MUTUAL FUND
DIRECT TRADING
SITUATION
n Increased Complexity
n How We Got Here
n Cost Comparison ....... 3
REGULATORY
BACKDROP .............. 8
SURVEY FINDINGS .. 10
DISCOVERY: THE
DIRECT TRADING
MATURITY CURVE ... 13
DEVELOPING AN
ACTION PLAN ........ 16
CONCLUSION ......... 18
SHAR ING OUR KNOWLEDGE FOR YOUR SUCCESS
(continued on next page)
Survey Findings
After discussing a wide range of topics with broker/dealers,
fi ve key fi ndings were observed:
1. A fi rm’s level of control over brokers and advisors is a key
driver of mutual fund direct business
2 . Compliance with regulatory requirements and a consol-
idated view of the fi rms’ relationship with clients are the
largest perceived benefi ts of transacting via a brokerage
platform
3. Ticket charges and inactivity fees are the two most
intractable barriers to higher utilization of fi rms’
brokerage platforms relative to mutual fund direct
business
4 . A signifi cant portion of fi rms have invested in aggregation
technology
5 . The most prevalent model for processing mutual fund
direct business provides the home offi ce with adequate
compliance supervision, but is also the least effi cient
Discovery: The Direct Trading
Maturity Curve
In the course of this research project, we discovered that
there is a maturity curve for fi rms interested in aggregating
their direct business and/or consolidating it on a brokerage
platform. Information gathered during the interviews
coupled with follow-up analysis was used to develop a
maturity curve (Exhibit 5) with respect to a fi rm’s ability to:
n track and monitor direct trading and associated client
information
n consolidate positions onto their brokerage platform
The curve is a representation of an “effi cient frontier” for
fi rms with varying abilities and motives to deal effectively
with the issues raised by mutual fund direct trading. Firms
may be able to evaluate where they lie on this curve in
order to understand their immediate action-items, and
what it might take to reach an optimized state.
HOW WE GOT HERE
All of the fi rms who discussed their situation refl ected back
on how they believe we got here from a time when trading
mutual funds directly was much simpler. We heard that the
primary drivers of direct mutual fund trading business had
included:
Firm Service Model — direct use of mutual fund
companies helps reduce client and account servicing
demands on the broker and advisor and on the broker/dealer
home offi ce
Paperwork — simplifi ed “check and app” workfl ow
Portability — the ease of updating accounts at the
mutual fund companies in the event the broker or
advisor switched fi rms
Product Gaps — the ability to purchase a wider range
of mutual fund investments versus what may be supported
on a brokerage platform
COST COMPARISON
Traditionally, it was thought that trading mutual funds
directly was free or very inexpensive. In response to the
concern that it is costly to trade directly, we developed a
cost comparison model. The results estimated that typical
operational cost savings from automating trading processes
may be nearly 50%. And, once the broker and advisor
“hidden” time costs are included in the equation, we found
that it is over 90% more costly to run a “check and app”
business than to utilize a single brokerage trading platform.
Regulatory Backdrop
The most frequently mentioned topic was that of the
changing regulatory environment. Firms shared that direct
mutual fund trading is a signifi cant factor in their ability to
manage risk in today’s environment of increased regulatory
scrutiny. This impacts four critical areas of compliance
concern including:
1. Books and Records (SEC Rule 17a-3)
2 . Investment Suitability
3. Breakpoint Calculations
4 . Anti-money Laundering
EXECUTIVE SUMMARY continued
(continued on next page)
3
Developing an Action Plan
Regardless of business model, most fi rms may want to
consider performing the following steps to determine their
own situation, fi nd where they sit on the direct maturity
trading curve and map a course of action if applicable:
1. Perform a Direct Trading Cost Analysis
2 . Develop a Comprehensive Consolidation Strategy
3. Optimize the Firm’s Approach to Aggregation
4 . Utilize an Order Capture System for Direct Business
Each fi rm’s results will vary, but overall broker/dealers
might expect that consolidation of accounts onto a single
brokerage platform could potentially provide a high
number of business management benefi ts. For fi rms
with large books of legacy direct accounts, however,
consolidation alone is not always the optimal solution.
In particular, those fi rms with business models focused
away from traditional brokerage products will likely
leverage a combination of funds consolidation and data
aggregation strategies to achieve the same goals.
SURVEY BACKGROUND
In late 2006, National Financial engaged IBM Global
Business Services to interview a cross-section of broker/
dealer clients. The goal was to quantify best practices
for direct processing of mutual funds. The research
encompassed non-attributable interviews with individuals
from operations, compliance, and management from 14
different broker/dealers.1 The interviewers probed for client
perceptions of the costs and regulatory compliance impact
of direct trading as well as the various considerations behind
the continuation of this practice.
The fi rms participating in the survey each had on average
approximately $2 billion in directly held mutual fund assets,
300,000 customer accounts and an average account size
of $6,600.5
MUTUAL FUND DIRECT
TRADING SITUATION
Increased Complexity
More than half of all mutual fund purchases are still made
directly via the “check and app” method.2 Historically, this
simply meant brokers and advisors fi lled out a printed
account form, had their clients review and sign the
application and write a paper check. These items were sent
directly to a mutual fund company for processing. Today, the
process is more involved: brokers and advisors are required
to forward the application to the home offi ce or an Offi ce
of Supervisory Jurisdiction (OSJ), where it is reviewed and
approved and then repackaged and delivered to the fund
company. This may add additional time to the process.
This represents an enormous industry-wide effi ciency loss,
requiring large staffs to handle physical paperwork (with
potential for increased risk of error), considerable mailing
costs, and long cycle times compared to electronic trading.
The complexity of this approach is illustrated in Exhibit 1
(on page 4). As shown, the direct process entails myriad
steps and touches to invest a single check with a mutual
fund company. There are generally four parties involved
just to deposit a check: the client, the broker or advisor,
the Home Offi ce and/or OSJ, and the mutual fund company.
It may take additional time for the trade to be placed and
the investment made.
Exhibit 2 (on page 4) shows the more streamlined and
automated processing for transactions conducted through
a brokerage platform. As it indicates, eliminating the need
to move a paper application can reduce the number of touch
points and shortens the time before order and execution.
There are compelling compliance and business management
rationales for aggregating and/or consolidating mutual fund
business onto a single brokerage clearing platform. When
asked why they have not fully migrated the mutual fund
business, certain broker/dealers explained their perspectives
on how the processing of direct mutual fund business
evolved, and what they are facing as they try to manage
a legacy business in a new regulatory environment.
EXHIBIT 2
BROKERAGE CLEARING PLATFORM MODEL
Source: IBM Global Business Services, 2007 Assumes investor account has previously been established.
*CIP is “Client Identification Program”; KYC is “Know Your Customer”; AML is “Anti-Money Laundering”
Pre-Trade Trade Date Post-Trade
Generate and distribute
paper applications
Calculate breakpoints
Principal Review
In good order?
KYC/AML*processes
Receive check and
application
Principal Signoff
Make investment
Send Commission
checks
Receive commission
Generate appropriate
17a-3 notices
Receivestatements from fund company
Confirm Identity and
CIP*
Receive commission
checks
Process, reconcile
and calculate payouts
Update client database
Return application and check
to rep
Receive applications
Complete application
Sign application
and provide check
Client provides missing
information
Returns check and
application to Rep
Forward materials to
broker/dealeror OSJ
Check for completeness
Obtain application
with signature and check
FU
ND
CO
MP
AN
YB
RO
KE
R/D
EA
LE
RIN
VE
STM
EN
T R
EP
CLIE
NT
Follows up with client
Generatestatements,
tax reports, etc
Forward materials to
fund company
NO
YES
EXHIBIT 1
( IN )DIRECT TO FUND VIA HOME OFFICE MODEL
Source: National Financial, approximation of processing, 2007
*CIP is “Client Identification Program”; KYC is “Know Your Customer”
5
How We Got Here
1. REGULATORY ENVIRONMENT
Firms surveyed report that direct mutual fund trading is a
signifi cant factor in their ability to manage risk in today’s
environment of increased regulatory scrutiny. Indeed, a fi rm’s
ability to meet key compliance duties has never been of higher
importance. Even though the positions are held directly
with the mutual fund companies, fi rms retain the following
regulatory responsibilities (described briefl y on pages 8–9)
which may require signifi cant time and expense:
1. Books and Records
2 . Investment Suitability
3. Breakpoint Calculations
4 . Anti-money Laundering
2 . FIRM SERVICE MODELS
Looking at Exhibit 3, we see a fi rm’s traditional line of
business is one of the strongest predictors as to the depth
of its existing book of direct business.
The “check and app” business, with its extremely low
barriers to entry, has had many benefi ts in the past for
“adjacent-industry” fi rms, such as traditional insurance
fi rms that expanded to sell mutual fund IRAs or hold mutual
funds in non-retirement accounts. Benefi ts included:
n offering a path of least resistance to expand their mutual
fund product offerings
n shifting responsibility to the mutual fund company
for providing both regulatory and general information
concerning the account to the shareholder
n reducing fi rms’ back offi ce and service personnel costs
From the broker and advisor perspective, trading direct
has also provided benefi ts by:
n shifting responsibility of answering shareholder questions
to the mutual fund company
n shifting routine account servicing to the mutual fund
company — processing checks, redemption requests,
reallocations, etc.
Generally, outsourcing securities back offi ce activities
helps enable mutual fund sales with minimal investment
in the infrastructure to facilitate such sales. However,
this practice also presents a fi rm with regulatory challenges
with respect to meeting obligations to maintain client records.
3. PAPERWORK
As discussed above, the ease of using pen and paper carried
benefi ts in the past, often allowing fi rms to grow with
minimal investment. As the fi nancial services business and
the regulations have become increasingly complex, it has
been challenging to keep up with the changing supervisory
requirements. This has created a need to shift to a more
automated model. Firms cannot sacrifi ce their regulatory
supervision, and manual supervision is no longer a viable
solution. As a result, it takes a greater number of hands to
touch each new piece of information concerning a client.
Firms that have moved to a fully automated order-entry
environment such as a brokerage platform, have experienced
signifi cant benefi ts:
n a single account opening process
n same-day trading
n automated tools for use in the enforcement of regulatory
requirements and surveillance, and
n ability to more quickly move money between different
mutual fund families.
A failure to pursue this streamlined approach may result in
decreasing client satisfaction levels over time — a matter that
should be of no small interest to the broker and advisor.
Insurance B/D Bank Independents with
Limited Product RangeIndependents with
Full Service Offerings
CORE PRODUCT LINE n Annuitiesn Life
n Cashn Lending
n Planning
n Selected product set
n MFsn Securitiesn Annuities
PROPORTIONAL
DIRECT TRADING
High Medium High Medium–Low
EXHIBIT 3
OVERVIEW OF DIRECT TRADING PROFILES BY FIRM TYPE*
*Not indicative or representative of all financial firms in these channels
4 . PORTABILITY
Traditionally, brokers and advisors may have preferred to
hold client assets directly with a mutual fund company
because of portability issues. This enabled them to retain
their own clients and revenue stream when switching fi rms,
simply by changing the broker of record at the mutual fund
company level. Today, changing the broker of record requires
that an account be repapered with the client’s positive
consent. However, brokers and advisors have historically
perceived a degree of control when choosing direct trading,
and this has contributed to the continuation of this practice.
Direct trading is especially common today under the
independent advisor model.
5 . PRODUCT GAPS
Not every product can be carried on every brokerage
clearing platform. As a result, some fi rms may never be
completely out of the business of transacting mutual
funds directly. However, many leading brokerage clearing
platforms provide access to the vast majority of products
as measured by industry sales volumes. Most platforms
cannot accommodate the entire universe of mutual funds in
every product type. This is one of the primary reasons that
consolidation alone may not be a “total solution.” A hybrid
consolidation/aggregation technology solution may better
meet fi rms’ needs.
Cost Comparison
Explicit ticket charges and fees (low balance, inactivity fee)
applied by brokerage and/or clearing fi rms are readily visible
to clients and can impact clients differently:
n A ticket charge can be deemed insignifi cant relative to the
size of a client’s invested assets; or,
n In the case of a small account, ticket charges and annual
fees may seem to represent too large a portion of the
invested assets.
In truth, a ticket charge may or may not affect an investor
depending on the investor’s specifi c situation. Many mutual
fund companies charge their own low-balance fees. This
means that any client who is invested in more than one fund
family is often better off paying this fee once on the brokerage
platform, rather than paying a higher aggregate fee to two or
more fund companies.
Brokers and advisors frequently place smaller investments direct
with fund companies because servicing is perceived as being
“free.” Meanwhile, unseen by the broker or advisor, the fi rm
assumes additional costs and obligations related to tracking and
maintaining up-to-date books and records for these positions
– costs that are passed on in some fashion. In short, the
distinction as to which model is ultimately less expensive (and
for whom) is somewhat more subtle than it may fi rst appear.
Exhibit 4, “Hypothetical Firm Run Rates for Mutual Fund
Processing,” illustrates an example of two cost model
scenarios: 1) trading mutual funds direct (“check and app”
model) versus 2) trading mutual funds on a brokerage
platform (brokerage model). This example does not represent
any one fi rm, but rather is a composite of the types of
costs a fi rm might consider when assessing its own mutual
fund direct situation. In actual terms, a fi rm will likely fi nd
itself somewhere between the two models and will have to
adjust the components and values for its own situation. A
hypothetical case comparison of these two approaches was
run assuming the following:
n Two hypothetical broker/dealers with identical character-
istics: 150 brokers and advisors working 50 weeks per
year; 175,000 accounts with an average account balance
of $8,000; $1.4B assets; 40,000 new transactions/year.
n Compensation was the same in both models: broker’s
and advisor’s compensation was $100,000 per year ($50/hour)
while the home offi ce staff compensation was $50,000/year.
7
estimated $1.477MM vs. $1.1MM in the “check and app”
model. However, combining both sections, we estimate the
total cost in this example is 97% more costly to trade direct
versus trading on a single brokerage platform.
While it is not possible to be precise in choosing costs to
apply in any illustration, it does not appear possible that
direct “check and app” processing is less costly than its
alternatives, let alone “free.” Every minute the broker or
advisor is engaged in manually-intensive back or middle-
offi ce activities, it is both an actual cost and an opportunity
cost. This labor could be provided at a much lower fi xed
cost in the back offi ce or by the broker/dealer’s clearing fi rm.
Broker and advisor cost assumptions: The time a broker
or advisor spends on the varying tasks to support the direct
process can be high. Here we’ve assumed a relatively modest
4.5 hours per week to perform such tasks as processing
the application and check and later reconciling multiple
statements and calculating breakpoints. For a fi rm with
150 brokers and advisors, this cost of manual processing
is substantial: over $2.7MM in our estimate.
Home offi ce cost assumptions: Under the brokerage model,
ticket charges will be specifi c and visible. We assumed that
more customer service staff would be needed in the brokerage
model. The costs at the Home Offi ce are therefore 35% higher:
EXHIBIT 4
HYPOTHETICAL FIRM “RUN RATES” FOR MUTUAL FUND PROCESSING MODELS
Broker/Advisor Cost Estimates “Check & App” Model Brokerage Model
Time to process physical applications and checks 2 hr/wk $5,000 0 hr/wk $0
Time to copy applications 0.5 hr/wk $1,250 0 hr/wk $0
Overnight delivery fees $75/wk $3,750 $0/wk $0
Time spent reviewing, consolidating,
reconciling mutual fund family statements1 hr/wk $2,500 0 hr/wk $0
Cost of consolidated reporting
(imposed by broker/dealer)$250/month $3,000 $250/month $3,000
Time spent calculating breakpoints, verifying
prospectus compliance, etc.
1 hr/wk $2,500 0 hr/wk $0
TOTAL BROKER/ADVISOR HOURS/WEEK 4 .5 0
ANNUAL EST. COST PER BROKER/ADVISOR $18 ,000 $3 ,000
TOTAL EST. COST (BROKER/ADVISOR) $2 ,700 ,000 $450 ,000
Home Offi ce Cost Estimates “Check & App” Model Brokerage Model
Paperwork review 3 FTE* $150,000 0 FTE $0
Mailroom/fi le room/document imaging .5 FTE $25,000 0 FTE $0
Overnight delivery fees $150/day $39,000 $0/day $0
Customer service (shareholder or rep) .25 FTE $12,500 4 FTE $200,000
Compliance (suitability, breakpoints) 2 FTE $100,000 1 FTE $50,000
Checks and wire processing 0.25 FTE $12,500 1 FTE $50,000
Commissions processing 0.25 FTE $12,500 0.25 FTE $12,500
Position aggregation (Staff) 0.5 FTE $25,000 0 FTE $0
Position aggregation (Technology) $500,000/yr $500,000 $500,000/yr $500,000
Regulatory reporting and follow-up 0.5 FTE $25,000 0.5 FTE $25,000
Books and Records (Staff) 2 FTE $100,000 0 FTE $0
Books and Records (Technology) $100,000/yr $100,000 $0/yr $0
Ticket charges (absorbed) $0 $0 $16/ticket $640,000
TOTAL HOME OFFICE FTE ’S 9 .25 6.75
ANNUAL HOME OFFICE COST ESTIMATES $1 ,101 ,500 $1 ,477,500
TOTAL COST EST. (BROKER/ADVISOR + HOME OFFICE) $3 ,801 ,500 $1 ,927,500
EST. COST PER TRANSACTION $95 .04 $48.19
*FTE = “full-time equivalent” staff member
1. BOOKS AND RECORDS
The primary regulation affecting a broker/dealer’s direct
mutual fund business is SEC Rule 17a-3, commonly referred
to as “Books and Records.”6
n Practically, fi rms must maintain detailed name and address
records of the client plus asset and income information,
investment objectives, and the client’s and supervisory
principal’s signatures. Firms must verify this information
with clients within 30 days of account opening or upon
change of information, and at least once every 36 months
thereafter.7
n Firms are required to produce this information for all
positions where they are listed as the broker of record.
However, they may have concerns about whether they
are capturing the most current client information and are
able to maintain the same quality of controls in the direct
business as they can in-house.
n Once direct positions are substantially identifi ed, the
next step is to confi rm the account information with
the clients. With the realities of doing business today,
with brokers and advisors changing jobs frequently, with
clients changing brokers and advisors more frequently,
how might a broker/dealer remain confi dent that all of the
client information is the most current and accurate? Due
to client confusion over frequent and complex paperwork,
they might not have properly informed all of the parties
who need to know of a change that impacts Books
and Records.
n Further, in today’s fast-moving markets where companies
buy or merge with other companies, a client may well
be unaware or unfamiliar with new names of the new
companies or with new paperwork required. In short,
fi rms that rely on direct sales may fi nd themselves trapped
in a vicious cycle of chasing and then confi rming client
account data necessary for compliance.
2 . SUITABILITY
Underlying SEC Rule 17a-3 is the requirement of investment
suitability.
n As noted above, fi rms must be able to demonstrate to
regulators that a well-founded suitability determination
was made at the time of an investment recommendation.
Small-to-medium sized fi rms, when compared to their
larger counterparts, may experience a more magnifi ed
challenge in monitoring suitability because they may not
have signifi cant sources of capital required to implement
automated surveillance. They may continue to rely on
manual compliance reviews, which is increasingly diffi cult
and time-consuming.
n In some cases, a broker or advisor may have made a
mutual fund recommendation and placed the transaction
directly. Some fi rms surveyed expressed concern over
their fi rm’s accountability for the recommendation and
the challenges inherent in properly documenting
subsequent changes in such a client’s fi nancial situation
or fi nancial goals.
REGULATORY BACKDROP
9
3. SALES CHARGE DISCOUNT BREAKPOINTS
Firms must have procedures reasonably designed to
ascertain information necessary to determine the availability
and appropriate level of breakpoints.8
n The SEC’s Offi ce of Compliance Inspections and
Examinations, the NASD and the New York Stock
Exchange (NYSE) have increased their reviews of fi nancial
services fi rms over the past several years. They look
for violations of Books and Records rules, disclosures,
suitability requirements, and failure to provide breakpoint
pricing, among other areas of concern. During these
sweeps, they have uncovered issues including, but
not limited to, failure to provide breakpoint pricing,
weak-to-nonexistent internal controls, and unsatisfactory
compliance programs/oversight procedures. The results
are that fi rms must take corrective action and often pay a
fi ne. From 2001–2006, fi nancial services fi rms have been
fi ned for “securities-related disgorgements and penalties”
in aggregate from $522M (2001) to a high of $2B (2003).
Most recently, 2006 fi nes were $1.5B for identifi ed
violations.9
n In the SEC sweep, “the most frequent causes for not
providing a breakpoint discount were not linking a client’s
ownership of different funds in the same mutual fund
family, not linking shares owned in a fund or fund family in
all of a client’s accounts at the fi rm, and not linking shares
owned in the same fund or fund family by persons related
to the client (spouse, children) in accounts at the fi rm.”10
n Firms that trade direct may still rely on determinations
made by their registered brokers and advisors about
whether a client is entitled to a breakpoint discount.
Such fi rms may not have access to automated back-
offi ce processes and systems designed to identify and
consolidate these positions associated with direct mutual
fund business.
4 . ANTI -MONEY LAUNDERING
A provision of the USA PATRIOT Act* requires fi nancial
institutions, including broker/dealers, to develop and
implement comprehensive anti-money laundering
(AML) programs.
n Generally, under the USA PATRIOT Act’s Client Identifi -
cation Program (CIP), fi nancial institutions are required
to implement reasonable procedures for (a) verifying the
identity of any person seeking to open an account; (b)
maintaining records of the information used to verify the
person’s identity, including name, full residential address,
date of birth, and taxpayer identifi cation number or
other identifi er; and (c) determining whether the person
appears on any lists of known or suspected terrorists or
terrorist organizations.11
n The SEC has specifi cally confi rmed the applicability of
a fi rm’s AML responsibilities to the sale of mutual fund
shares or variable life annuities on a direct basis.11
n A provision of CIP allows a fi rm to place reliance on
another fi nancial institution to perform the fi rm’s
CIP. However, both parties must enter into a contract
requiring annual certifi cation that meets all of the
broker/dealer’s CIP. Otherwise, the fi rm remains solely
responsible for CIP.12
* Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, known as USA PATRIOT Act.
SURVEY FINDINGS
Our research suggests that fi rms lie along a natural maturity
curve with respect to how they realistically optimize their
direct mutual fund trading practices. Let’s take a closer look
at some of the key fi ndings that emerged from this analysis:
1. FINDING: A fi rm’s level of control over brokers and
advisors is a key driver of direct business
At fi rst blush, fi rm affi liation appears to be a key driver as to
whether fi rms will maintain large subscription-away books
of business and whether they will continue to transact direct.
The average broker/dealer paying W-2 wages in our survey
was booking 19% or fewer of its new transactions direct,
while the mix of direct business was 67% for the average
insurance-affi liated independent advisor broker/dealer.
However, these numbers more directly refl ect the amount
of control these fi rms tend to exercise over their brokers
and advisors. The two principal business models are the
banking/employee W-2 wage model and the independent
advisor model. Firms that employ their brokers and advisors
as W-2 employees or otherwise exercise tighter control than
the traditional independent advisor model allows will tend
to do more business on the brokerage platform. Exhibit 5
below summarizes the two principal business models and
how direct trading is typically treated under each.
There may also be a big fi rm/small fi rm effect, with smaller
fi rms doing much more direct business relative to their
size, and larger fi rms being oriented towards their clearing
platforms and a truly electronic order-entry environment.
Note that 85% of fi rms under the independent advisor
model mark-up the brokerage clearing fee to help
compensate for some of their own unrecovered costs for
inactive accounts. However, mark-ups tend to be relatively
minor and are not really a source of revenue for fi rms.
While brokers and advisors are much less likely to trade
on a brokerage platform in this model because of the ticket
charges and other fees, they will tend to place the business of
their largest clients on the brokerage platform; both because
of the larger positions held by these clients and their more
complex fi nancial needs.
2 . FINDING: Compliance with regulatory require-
ments and a consolidated view of the fi rms’
relationship with clients are the largest perceived
benefi ts of transacting via a brokerage platform
Clearly, one of the primary drivers leading fi rms to
consolidate onto a brokerage platform is regulatory
compliance. Specifi cally, fi rms need the ability to conduct
surveillance and run reports to help ensure proper
breakpoint and books and records compliance from a
single source.
In addition, most fi rms surveyed cited the ability to access a
consolidated view of the fi rm’s relationship with the client,
consolidated statements and tax reporting as key benefi ts.
These fi ndings are found in Exhibit 6 on page 11.
Employee Model Independent Advisor Model
Brokers and advisors are employed directly as
W-2 employeesBrokers and advisors are more independent or 1099
employees
Brokers and advisors tend to trade on a brokerage platform; most new business required to be on brokerage platform
Brokers and advisors tend to trade directly with mutual fund
companies using “check & app” process
Parent fi rm absorbs brokerage clearing fi rm charges and
systems expenses
Parent fi rm passes clearing fi rm charges through to broker and advisor
Firm absorbs costs for using aggregation technology Firm charges brokers and advisors for technology use, such
as aggregation
Ticket charges and other fees for trading are passed through
to the clientFees for inactive accounts or low balances are passed
through to the client
Compliance is centralized Compliance is decentralized
EXHIBIT 5
Source: IBM Global Business Services, survey findings, 2007
11
3. FINDING: Ticket charges and inactivity fees are the
two most intractable barriers to higher utilization of
fi rms’ brokerage platforms relative to direct business
Firms surveyed provided insight into why it is challenging to
1) recapture mutual funds held away and 2) achieve higher
success rates using a central brokerage platform (Exhibit
7). 75% of surveyed fi rms reported that ticket charges were
a signifi cant barrier. One-third reported that unsupported
product types or accounts on a brokerage platform were
clear deterrents to changing behavior. Some brokers and
advisors may be consolidating when possible, but they must
seek alternative solutions for business that cannot be transi-
tioned onto a brokerage platform. If costs and resources
required are too high, fi rms will simply not consolidate.
These include time and resources to undertake research
intended to understand the broker/dealer’s true cost of doing
business and on home offi ce capabilities to deliver this kind
of effort.
EXHIBIT 6
PERCEIVED BENEFITS OF CONSOLIDATING ON A BROKERAGE PLATFORM
Source: IBM Global Business Services, survey findings, 2007
Source: IBM Global Business Services, survey findings, 2007
EXHIBIT 7
SIGNIFICANT BARRIERS TO RECAPTURING POSITIONS
HELD AWAY
4 . FINDING: A signifi cant portion of fi rms have
invested in aggregation technology
More than 90% of fi rms surveyed are already employing
some form of aggregation technology in order to account
for positions held away. 56% of fi rms providing this service
charge a user fee of some kind back to the broker and
advisor, should they elect to utilize the service, with the
remaining fi rms absorbing the user fee as a cost of business
(Exhibit 8).
Several fi rms in our survey indicated they had purchased
an aggregation solution. Others in our survey reported
they have gone quite a bit deeper. Some implemented
full portfolio accounting systems to shadow books and
records. Others integrated services with their internal
customer relationship management (CRM) system or broker
workstations to improve processing effi ciency and quality.
5 . FINDING: The most prevalent model for processing
mutual fund direct business provides the home offi ce
with adequate compliance supervision, but is also the
least effi cient
One approach to managing control and supervision over
the “check and app” business that is effective, but potentially
costly, has been the redesign of procedures to route completed
applications to the home offi ce or offi ce of supervisory
jurisdiction before they are sent to the mutual fund com-
panies. This affords the home offi ce ample time to conduct
various functions such as completeness reviews, principal
review, verify prospectus compliance, capture the details
of the transaction and suitability information for Books and
Records purposes.
Unfortunately, this model may potentially add days to the
time it takes to process a purchase of mutual fund shares.
Additionally, fi rms incur additional costs by having staff
manually review and process applications, an expense that is
avoided in an order-entry environment. Moreover, overnight
fees between brokers and advisors, branches, the home
offi ce, and fund companies can be fairly substantial for
a large operation.
The survey also identifi ed three other models of direct
mutual fund processing. In these models brokers and
advisors send applications to the:
n mutual fund company directly
n home offi ce for processing on their brokerage system
n home offi ce for processing on another proprietary system
Note that relatively few fi rms participating in our survey
still permit brokers or advisors to send applications directly
to a mutual fund company. Most fl ow back to the home
offi ce fi rst.
EXHIBIT 8
FIRMS OFFERING AGGREGATION TECHNOLOGY TODAY
AND PRICING MODELS
Source: IBM Global Business Services, survey findings, 2007
13
DISCOVERY: THE DIRECT TRADING MATURITY CURVE
Source: IBM Global Business Services, 2007
EXHIBIT 9
DIRECT TRADING MATURITY CURVE CONCEPTUAL FRAMEWORK
For example, in the
divergent scenario, “fi t to
objective” may be relatively
high, quite close to the
more effi cient optimized
model; however, the initial
development and on-going
support costs are excessive.
Although not plotted here,
one can imagine that initial
and annual costs are also
large for divergent fi rms,
who have more than likely
worked their way progres-
sively up the maturity curve
by continuing to invest
in process and system
improvements over time.
In the course of this research project, the interviews, coupled
with follow-on analysis, helped develop a maturity curve
for fi rms in aggregating their direct business and/or consoli-
dating it on a brokerage platform (Exhibit 9).
Firms may fi nd it helpful to evaluate where they lie on
the maturity curve in order to understand their immediate
action items as well as to develop a plan to reach an
optimized situation. The direct trading maturity conceptual
framework provides one means of analyzing a fi rm’s
positioning relative to its peers. Firms may simply choose
the maturity stage which best applies (based on defi nitions
on pages 14 and 15), or develop new models with
customized objectives and priorities.
This curve follows an arch-shaped path when plotting
two parameters: 1) the level of investment to achieve a
compliance solution and 2) the realized benefi ts of that
investment. We defi ned “realized benefi ts” as an adjustment
between benefi ts and risks as follows:
(potential benefi ts to be achieved)
–
(any potential compliance risk of taking no action)
=
“REALIZED BENEFITS”
Specifi cally, development of the curve involved plotting
a set of 14 criteria that labeled “fi t to objectives” against a
simple marginal investment term of high/med/low/none.
The “fi t to objectives” results were determined by calculating
a combination of factors (shown in Exhibit 10 on the
following page) with a simple weighting. Then they were
standardized against the raw scores received from the
participating fi rms in the survey. The result is refl ected
at each stage on the maturity curve.
Each fi rm is encouraged to consider the factors that best fi t
their fi rm’s own requirements. In undertaking an analysis,
a fi rm may choose to use different objectives and/or
weights. However, the regulatory objectives should
remain a requirement of your analysis.
EMERGENT
COMMON FIRM ATTRIBUTES
n Taking feeds from its largest funds families or positions are likely being taken
into a local database.
n Maintaining regulatory compliance by updating client information for books
and records purposes
SUGGESTED ACTION PLAN
1. Confi rm account information by mailing necessary client letters and processing responses for accuracy and completeness.
2 . Begin the gap analysis required to support a more permanent solution, considering benefi ts consolidation to a
single platform vs. aggregation
3. May choose to consider a third-party solution that would bypass the time and costs of further internal technology
investment and a more immediate transition to the Optimized stage.
Marginal Investment Low
Residual Risk Medium
Fit to Objectives Low
BASELINE
COMMON FIRM ATTRIBUTES
n Investing in some form of aggregation technology to account for
mutual fund direct positionsn Beginning to consolidate on brokerage platform to support and facilitate
n Compliant with regulatory obligationsn Effi ciencies not fully realized
SUGGESTED ACTION PLAN
1. Assess full impact of prior fi nancial decisions: signifi cant initial costs may have been spent and fi rm may
be reluctant to abandon their existing investments.
2 . Consider further assessments necessary to reach optimized stage:n Assess ongoing and annual costs, including costs of additional human resources requiredn Re-evaluate complexity of operating multiple systemsn Monitor success that brokers and advisors are or are not having and solicit feedback for improvements
3. Consider outsourcing to a third party at this time, before signifi cant dollars are spent on a non-ideal system.
Benefi t from improved, current technology that may also help brokers and advisors grow their books.
Marginal Investment Medium
Residual Risk Medium
Fit to Objectives Medium
Factor Weight
1. Automatically check orders for breakpoint calculations 5
2. Generate compliance and surveillance reports for all accounts 5
3. Provide a consolidated view of the relationship 5
4. Produce consolidated reports 5
5. Provide for centralized servicing of the relationship 5
6. Provide exposure information through a single platform 5
7. Increase productivity of the client relationship processes 5
8. Correctly attribute costs by trade, optimize business mix 5
9. Reduce administrative burden on brokers and advisors 5
10. Materially identify mutual fund positions held away 9
11. Demonstrate Books and Records compliance 9
12. Demonstrate compliance with suitability rules 9
13. Demonstrate breakpoints and/or prospectus terms compliance 9
14. Demonstrate AML compliance against subscription-away accounts 9
EXHIBIT 10
DEFINING “FIT TO OBJECTIVES” CRITERIA
Source: IBM Global Business Services, 2007
STAGES OF THE MATURITY CURVE: AN OVERVIEW
15
DIVERGENT
COMMON FIRM ATTRIBUTES
n Substantial continued investment in internal systems and processesn Multiple systems likely used to accommodate different products
n Providing sales force a view of the client and his/her assetsn Cross-selling of product to meet client’s fi nancial needs
SUGGESTED ACTION PLAN
1. Answer two key questions:
n “What are my total costs with these multiple systems?”
n “Is data management a core competency for every solution I previously selected?”
2 . Use answers to determine next course of action:
n Continue to spend incremental dollars on mandatory, but less-than-effi cient systems and processes; or
n Redistribute limited dollars between a new, modern, single, all-in-one solution and recruiting and retaining
brokers to generate higher returns in more areas of the business.
3. Build a business case analyzing outsourcing options and resources redeployment
Marginal Investment High
Residual Risk Low
Fit to Objectives High
OPTIMIZED
COMMON FIRM ATTRIBUTES
n Providing system functionality for consistent processing and workfl ows
for all mutual fund assets held away
n Utilizing effi cient data warehouse capabilities (including broker and advisor
and investor views of assets)
n Maintaining a lean manufacturing environment
SUGGESTED ACTION PLAN
Even at the Optimized stage, where a fi rm operates in a best-practices environment, there is room for improvement.
At this stage, fi rms will consistently drive improvements at the margin through continuous improvement in
operations. Optimized fi rms continually look for ways to improve their compliance processes and overall operating
model. They may ask any of the following questions:n Is there anything in my processing that gives me a true competitive market advantage?
n Where should I invest today to be in the best position for regulatory and competitive challenges of tomorrow?
n Which parts of my value chain are best outsourced to more effi cient, commodity processors (economies of scale,
manage regulatory change)?
n Are my operations unique and value-creating, or are they investments in infrastructure resulting from the cost of
doing business?
n What am I spending to maintain this process in-house? Is it the most effi cient allocation of my marginal dollar?n In which scenarios can I process least expensively? Are there ways to infl uence how transactions will be processed,
or scenarios in which it’s best to route certain types of transactions elsewhere for processing?
n What tools and/or analysis can I provide to the front offi ce to help drive client penetration and profi tability?
Marginal Investment Medium
Residual Risk Low
Fit to Objectives High
Consolidating mutual fund positions onto a single brokerage
platform potentially provides the highest number of business
management benefi ts. For fi rms with large books of legacy
direct accounts, however, consolidation alone is not always
the optimal solution. Firms may face signifi cant costs
including costs to meet regulatory compliance requirements
and other business costs when working to streamline
their processes.
In addition, those fi rms with business models focused away
from traditional brokerage products will also likely leverage
a combination of funds consolidation and data aggregation
strategies to achieve their goals. For fi rms whose product
mix cannot be supported by consolidation (life insurance-
driven), aggregation technologies provide a somewhat more
complex, but reasonable alternative.13
As shown on page 13, fi rms can be placed along the full
spectrum of the Direct Trading Maturity Curve in these
general categories:
n Firms in the early stages of maturity — tend to suffer
from poor risk/reward profi les as technology investments
may be lacking.
n Mature fi rms — regulatory risk is low and additional
benefi ts of aggregation or consolidation beyond
compliance (process automation, enhanced prospecting
capabilities) begin to accrue.
n Firms in the middle — between these states lie a range
of scenarios as fi rms balance the cost of technology
against the goals of lowering regulatory risk and
expanding client views.
Every fi rm is encouraged to explore where they fall on the
Direct Trading Maturity Curve and undertake analyses
of how they can most quickly move to optimal states. As
part of this process, fi rms may want to consider taking the
following steps:
1
2
1. PERFORM A DIRECT TRADING COST
ANALYSIS.
Determine whether the revenues tied to the direct business
justify the costs and risks that accrue to your fi rm. This
analysis should include an attempt to calculate a “virtual
charge” that represents the total direct account service cost
to the fi rm. Examples of attributable costs include:
n staff time spent processing and reviewing applications
n overnight delivery charges for physical applications
n technology for: position aggregation, account feeds
from mutual fund companies, imaging and document
management
Some fi rms allow mutual fund trades to be placed direct if
they are below a specifi c threshold (often, $5,000 or less).
The client does not incur a brokerage ticket charge. The
fi rm may then be able to focus its efforts on the benefi ts of
consolidating larger client relationships onto its brokerage
platform. However, the fi rm continues to assume the cost of
providing two separate infrastructures for both regulatory
compliance and position aggregation.
2 . DEVELOP A COMPREHENSIVE
CONSOLIDATION STRATEGY.
To the extent consolidation can be achieved it will support
the most robust package of operational effi ciencies,
relationship management capabilities and client service
delivery benefi ts such as consolidated statements and
tax reporting. Determine to what degree and how best
to drive consolidation of mutual fund positions onto the
brokerage platform. Consider viability of specifi c steps,
such as incentivizing brokers and advisors to trade through
the brokerage platform via differential ticket charges and
recapturing positions by withholding commissions on direct
business.
Firms following the consolidation path can expect some
resistance to change, especially among established brokers
and advisors accustomed to doing business a certain way.
Thus, a critical piece of any consolidation strategy will be
DEVELOPING AN ACTION PLAN
17
3
4to ensure that branch managers and brokers and advisors
understand the case for change. Brokers and advisors will of
course need to be trained on the procedures of consolidating
assets on the brokerage platform, but will also need to be
able to articulate the potential benefi ts to clients.
Where a fi rm has not maintained a deep relationship with
an investor, it should consider re-evaluating the relationship
prior to migrating assets onto the brokerage platform.14 Firms
with clients that cannot be located, or who do not respond
to requests to recertify the account, might consider resigning
as broker of record.15
3. OPTIMIZE THE FIRM ’S APPROACH
TO AGGREGATION.
Aggregation is correctly viewed as a critical mission in
today’s regulatory environment. Firms surveyed, with few
exceptions, utilized some form of aggregation technology in
order to help identify direct positions. Although clients still
receive multiple statements and tax forms in the aggregation
model, brokers and advisors do have the ability to build
an aggregated client statement and/or online view that
approximates what a client might see from brokerage.
At a minimum, aggregation technology used by fi rms
included taking feeds from the various mutual fund
companies into a third party or proprietary aggregation
system. Firms that have historically done business with a
limited number of preferred mutual fund companies should
have easy access to the records of their transfer agent. For
others, trailing commissions, whether received via electronic
feed or paper checks are probably the most obvious place
to start.
As indicated in the fi rm profi ling under the Direct Trading
Maturity Curve discussion, the aggregation path likely leads
in one of three directions:
n acquiring a comprehensive and mature vendor system
n outsourcing to a third party service provider
n leveraging a proprietary solution where it provides a
competitive advantage
4 . UTILIZE AN ORDER CAPTURE SYSTEM
FOR DIRECT BUSINESS.
Firms that continue to execute transactions direct should
consider implementing order-capture technology that
both collects the information at the time the order is taken
and retains it for Books and Records and other regulatory
compliance. Such a system will need to capture all of the
client information necessary for principal and suitability
review as well as breakpoint analysis. Books and Records
compliance can then be maintained directly from this
system.
Firms implementing such technology should be able to
offset the one-time cost of implementation by eliminating
or reducing recurring costs of manpower necessary to
review, process, and mail physical applications by brokers
and advisors as well as home offi ce staff. Overnight mailing
fees of mutual fund applications would be greatly reduced
and the client’s investment into their selected mutual fund
may be processed more timely.
There are products that simply cannot be carried on a fi rm’s
own platform due to the legal structures of those products.
529 College Savings Plans, 401(k), 403(b), and certain
types of insurance products are some examples of products
that must be held with the product provider. Therefore, no
fi rm can be entirely out of the mutual fund direct business.
A comprehensive solution that accounts for a fi rm’s entire
product mix including assets held away is required. While
some fi rms have, with individual successes, built such
systems, there is a broad market need for a more complete
solution. This solution should allow fi rms to effi ciently jump
from a complex state of basic recordkeeping regulations to
a region on the maturity curve where the benefi ts of new
technologies can be realized.
Firms are encouraged to undertake their own analysis to
determine if revenues tied to their mutual funds direct
business justify the accompanying costs and risks of
continuing to do direct business. Firms may choose to
pursue either an approach that emphasizes consolidation
or one that combines consolidation and aggregation,
accordingly. Generally, fi rms whose primary business is
brokerage are likely to consolidate direct positions onto
a brokerage clearing platform. Alternatively, those fi rms
primarily engaged in the sale of life insurance or other
products, particularly under an independent advisor
model, are likely to fi nd aggregation to be a more realistic
alternative.
Regardless of which route brokers and advisors believe
to be less costly, fi rms engaged any kind of traditional
“check and app” business are likely facing higher costs of
processing than those in a brokerage platform order entry
environment. Imputing the value of brokers’ and advisors’
time, just a few hours per week dedicated to labor-intensive
manual processing takes away from value-added activities, in
particular, when scaling over a large brokerage organization.
The “check and app” business is one of the last great
frontiers of ineffi ciency to be conquered by trailblazing
fi rms in the brokerage industry, and one that will continue
to pose great challenges from a process effi ciency, regulatory
compliance, and client servicing perspective. Realizing
this, forward-looking fi rms are moving to understand the
problem and the opportunities, and identify appropriate
solutions to carry them into a more optimized state.
CONCLUSION
19
IMPORTANT INFORMATION AND
METHODOLOGY ABOUT EXHIBIT 9
This conceptual framework was developed as a result of the
interviews with broker/dealers who responded to specifi c
questions about the amount of investment they have spent
to date dealing with their mutual fund direct business in the
more complex regulatory environment. They also responded
to each of the 14 factors as listed in Exhibit 10. A relatively
straightforward approach has been taken: a weighting of 5
if the factor impacts effi ciency; and a 9 for each factor that
is regulatory or “mandatory.”
Using a math model, the responses were tabulated then
stratifi ed as followed:
1. Factors 1-9 were weighted relative to the quantitative
results from each fi rm surveyed
2. Factors 10-14 were weighted relative to the results from
each fi rm surveyed
3. The weighted results were combined and indexed, and
the results were mapped on a scatter graph
The fi nal results were reported on the direct trading maturity
curve relative to the amount of spending reporting by each
fi rm. The spending categories were: None, Low, Medium,
High, and were self-reported by each fi rm.
1 The firms were bank-affiliated, insurance affiliated, and independents. 2 U.S. Securities and Exchange Commission, Staff Report: Joint SEC/NASD/NYSE Report of Examinations of Broker-Dealers Regarding Discounts on Front-End Sales Charges on Mutual Funds, March 2003, http://www.sec.gov/news/studies/breakpointrep.htm
3 2006 Investment Company Fact Book, 46th Edition, A Review of Trends and Activity in the Investment Company Industry, http://www.icifactbook.org/ 4 Fundamentals: Investment Company Institute Research in Brief, Vol.14, Number 3, April 2005, http://www.ici.org/pdf/fm-v14n3.pdf 5 The accounts cited in these statistics are generally individual retail accounts. Plans such as 529 college savings plans and small 401(k) and 403(b) plans,
which are generally required to be held direct, have been excluded from parts of this report that specifically address solutions to the “direct” problem. 6 Code of Regulations, Part 240.17a-3 under the Securities Exchange Act of 1934 7 Ibid 8 NASD - Special Notice to Members, December 2002, http://www.nasd.com/web/groups/rules_regs/documents/notice_to_members/nasdw_003029.pdf 9 Compiled from SEC Annual Reports: 2001–2006, www.sec.gov 10 NASD - Special Notice to Members, December 2002, http://www.nasd.com/web/groups/rules_regs/documents/notice_to_members/nasdw_003029.pdf 11 U.S. Securities and Exchange Commission, Joint Final Rule: Customer Identification Programs from Broker-Dealers, Release No. 34-47752, File No. S7-25-02, http://www.sec.gov/rules/final/34-47752.htm
12 Ibid 13 Defined as firms with low penetration in the traditional brokerage products and primary reliance on an alternative stream of business. 14 A typical situation might be a case where the original broker or advisor has left the firm and the firm has no other relationship with the client. 15 An important exception to this would be accounts that are unsupported on the brokerage platform (529 College Savings Plans, 401(k) and 403(b) retirement plans). Alternative procedures and controls for these accounts will need to be maintained.
IBM Global Business Services
National Financial selected IBM to conduct the
survey of 14 National Financial broker/dealer
clients. IBM provides business consulting through
its Global Business Services unit, which provides
consulting services on strategy, technology
and process for many leading fi nancial services
institutions worldwide.
© 2007 FMR Corp. All rights reserved.
FOR BROKER/DEALER USE ONLY.
National Financial Services LLC, Member NYSE, SIPC460051 1.845991.100 0707
2 0 0 S E A P O R T B O U L E VA R D
B O S T O N , M A 0 2 2 1 0
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