Awaiting profit stream from rising rates

Clearing and custody firms, like their broker-dealer brethren, continue to struggle with negligible returns on client cash caused by record low short-term interest rates. But with long-term interest rates bumping up in June, sentiment is becoming slightly more sanguine about the prospects for clearing and custody firms, which traditionally have profited from the spreads earned by holding clients’ cash.

Long-term interest rates spiked in June because of worries that the Federal Reserve Bank would begin curtailing its asset-purchasing program later this year. Short-term interest rates remained unchanged because they are based on the federal funds rate, which the Fed has kept at near zero since the financial crisis. It has signaled that it plans to keep that rate near zero until unemployment is 6.5%.

“With rate head winds turning into a slight tail wind, we believe a strong core business should support estimate revisions,” Alex Kramm, an analyst with UBS Securities LLC, wrote last month in a research note about TD Ameritrade Holding Corp.

SIZABLE STAKES

The stakes are sizable, Mr. Kramm said in an interview. Between 13% and 19% of client assets held with the large custodians sit in cash.

Potential interest rate increases are “the only thing I care about with Ameritrade and The Charles Schwab [Corp.], and LPL [Financial LLC] to some degree, too,” Mr. Kramm said. “Schwab is the most levered on a higher-interest-rate environment.”

Many clearing firm executives are resigned to the idea that short-term interest rates will remain depressed for the foreseeable future. The near-zero rates affect clients’ cash that is held in brokerage accounts.

An increase of a couple basis points in short-term rates is “immaterial for the retail investor,” said William Coppel, managing director with First Clearing LLC. “That’s minute stuff. I don’t want to diminish its importance, but that’s the reality. I don’t expect a whole lot to happen” with interest rates changing, he said.

“We don’t expect rates to go up real soon, although some people are more optimistic than others,” said Stephen Langlois, senior vice president at National Financial Services LLC, a unit of Fidelity Investments. “Broker-dealers still remain pretty cautious, particularly as they are paying attention to changes in regulation and technology in general.”

“For many firms, especially the broker-dealers, low interest rates cut into budgets and created thinner margins,” said Dennis Gallant, an industry consultant. “And that puts pressure on clearing and custody firms. Many broker-dealers are holding back on spending. They’re postponing a shift of a custodian or clearing firms, or adopting new technology.”

But the increase in long-term rates may bode better times.

“If those firms feel that interest rates are not getting worse, but a little better, there will be more optimism on spending money,” Mr. Gallant said.

And some are even a bit more optimistic than a year ago about a light at the end of the tunnel for zero interest rates on short-term cash.

“The thinking in the market has shifted. If you look at the forward-looking Fed funds curve, you see some potential movement in 2014 and furthermore in 2015,” said Dan Arnold, chief financial officer of LPL Financial LLC. “The debate is exactly when. Will it be early or in the middle of next year?”

Disagreement over monetary forecasts has led to some interesting contradictions across the industry.

Optimism on rates has pushed Raymond James & Associates Inc. to prepare mass-affluent clients for a potential change in rates, while pessimism on rates has pushed RBC Correspondent Services to think of new ways to create yield on client cash.

“When rates are virtually zero, there’s only one way for rates to go,” said Bill Van Law, president of Raymond James’ Investment Advisors Division, adding that recent comments from Federal Reserve officials indicate a potential increase in short-term interest rates.

“A year ago, that wasn’t in the cards,” Mr. Van Law said. “We’re trying to be ahead of this. So when rates rise, a methodology will be in place for clients’ cash sweep accounts,” he said.

READYING CLIENTS

Raymond James informed clients in July of the process and methodology it will employ in increasing rates. “It will vary depending on client size, starting with $100,000 in assets, and then $500,000 and then $1 million. We informed clients in their July account statements, and the timing to introduce this is the fall.”

“I think people do feel there is optimism but haven’t seen it in short-term rates,” said Craig Gordon, a director at RBC Correspondent Services. “We are actually looking at alternatives to money market funds.”

A new offering would affect clients’ short-term cash holdings, he said. “We’re in the works right now to make available an option to move client cash to [Royal Bank of Canada]. It would be an option for our clients with money in U.S. brokerage accounts.”

The clients’ cash would be used to make traditional loans in Canada, with the return to be shared with clients and the clearing firm. The goal would be to create a little extra yield to share with clients, he said. The trade-off is, the risk clients would take on by holding cash in Canada, where bank deposits are not insured by the Federal Deposit Insurance Corp., he said.

“There are still a lot of details to work out, but we wouldn’t be looking at this if there wasn’t uncertainty around rates,” Mr. Gordon said.

Though optimism about an eventual rise in interest rates is apparent among many clearing and custody executives, present-day reality has required a new way of thinking.

“Most successful firms have recognized that you can’t have a business dependent on the rate environment,” said James Crowley, managing director of Pershing LLC, who says the clearing and custody industries are adjusting to lower rates.

“We can only influence those things in our control. Outside our control, the free market will prevail,” he said.