The Blog Of The Securities Industry Professional Association

A Tale of Two Trades

A two trade guide to why Independent Firms are dying

Each week the headline of financial magazines highlight the latest Independent firm to fail and many people and pundits are scratching their heads trying to figure out why? The answer is actually quite simple if you analyze a single trade of stock from opposite sides. Years ago the 90% payout model worked for many upstart firms who would charge a high ticket fee of around $30.00 per trade and take 10% of all commissions earned by the broker. The broker usually worked as an Office of Supervisory Jurisdiction ( OSJ) and the brokerage firm itself would have indemnity clauses and other protections. Not only are those protections now worthless, but the regulatory burden placed on the Firm to oversee every aspect of the OSJ has made it incredibly expensive to conduct business profitably.

Let’s take a look at 2 brokers in 2 different offices both looking at British Petroleum for their customers for two different reasons. The first broker believes the spill is overblown and that with 64 billion in net profits the previous year and a dividend yield now approaching 9% it’s certainly worth a 10,000 share investment. The second broker believes the worst is yet to come and thinks BP could go bankrupt from this massive oil spill so he decides to take advantage for his customer who favors aggressive investing and he wants to go short 10,000 shares of BP.

10 years ago the fees for such a trade would range from 2.5 to 3.5% of the purchase price so on a purchase of 10k BP at approximately 37.00 the brokers commission would be almost $13,000. Likewise with the short sale the fee for the short would be the same so the firm itself would take 10% of $26,000 in commissions as well as some ticket charges that would net the firm almost $2700 for two orders. Not too shabby for a couple orders and this system worked for a few decades to make some of the largest firms on Wall Street. So what has changed that now has firms closing down after decades of profits? Regulatory, Compliance and Legal costs have skyrocketed to the point of no return. Analyzing the two trades above through 1995 eyes will no longer work and these same two trades will require a number of extra steps never before needed.

On the purchase side of the transaction, most operations would require Compliance approval before a trade this large is consummated. The client’s investment objectives as well as Financials would be reviewed prior to entry. In addition, due to increase pressure by Regulators over commissions, some compliance departments might be inclined to reduce the percent commission on the buy side. Once the trade is entered the firm has to make sure that the trade was properly submitted to the various recording agencies and ensure all those OATS and ACT reports are up to date and are being randomly checked. A trade this large would also be a trigger for various exception reports to be generated that supervisors must then review and document and show proof of review. The Firm’s Written Supervisory Procedures (WSPs) must also be checked to ensure that the firm has procedures in place for large block trades or high dollar amount trades. Heaven forbid this is going to be put on margin or you will have even greater reports and calls and supervision to show written proof about why the trade is suitable, how you demonstrated that you checked for it and how you will monitor the margin account going forward.

Now let’s take a look at the short side of the transaction. All the same reports and checks and risk management must be assessed. In addition, prior to entering the trade someone on your trade desk will have to make sure the stock is ‘borrowable’ from the street. Years ago all listed stock was considered marginable and borrowable but those days are now gone too. The short sale of the 10k BP would require the firm to first locate the stock and document that you made this determination. Reg. SHO as its known, has really had just one key effect: it has made borrowing or shorting stock incredibly expensive. In the case of this short sale, fees and interest from stock location services could end up costing hundreds if not thousands to the firm. So let’s go back and look at the Independent firms 10% retention of about $2700:

· Approve suitability of both trades by management.

· Make sure trades were reported to ACT, OATS

· Ensure best execution of trades and document.

· Review no less then 10 exception reports for both sides of the trade combined and distribute them to appropriate personnel.

· Ensure that Reg. SHO has been followed and documented

· Pay exorbitant short interest and locate fees

· Ensure the firms WSP’s are being followed for buy and sale

· If Margin is being used, document and review the accounts and show continued review of the accounts.

The staff necessary to conduct all of the following will easily eat up the $2700 since you must have experienced people in there. There’s just one little ‘expense’ left that has the ability to eat up a hundred times what the firm made on the trade. Despite a firm that documented each and every aspect of the trade and ensured suitability, one side of the trade will be right and the other wrong. Once a loss hits say 25-50k the trial attorneys will be circling the firm like sharks around an injured seal. Suddenly all the work, all the review, all the reports become just a technicality often overlooked by Arbitration panels as they review the inevitable law suits filed by ambulance chasing attorneys. If one side of the trade is right and made $50k, that means the other side was wrong and lost $50k so of course that means there was a breach of fiduciary duty. Between the legal fees, the man hours of production as well as the arbitration itself, this $2600 day may very well cost the firm $100,000. I wish I could say that was it but because of the Arbitration, many times FINRA will launch investigations into the trade, the brokers, the operations and more. In fact, the FINRA inquiry alone could wind up costing as much as a lawsuit. In many cases staff and executive management is called before a team of lawyers to take part in an On The Record (OTR) in which they try to determine if operational failures or supervision failures occurred. Even if FINRA finds no evidence of this, legal fees will be in excess of 25k! Of course there is always the possibility that FINRA may recommend formal charges for Failure to Supervise and for a mere $25k they will settle all charges. These two simple trades could end up costing the firm almost $300,000 dollars all because one side of the trade had to be wrong.

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June 7th, 2010


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