This article appears in the November 2020 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.
Thanks to efforts to cut compliance costs, stoke competition and realign the investment industry’s regulatory framework, a renaissance for independent investment dealers finally may be on the horizon.
For years, doomsayers have been writing an obituary for small, independent investment dealers. The channel has faced a legion of challenges, from tough market conditions and macroeconomic headwinds to ever-growing regulatory and technology demands.
However, with the prospect of significant reforms at hand, the fortunes of small dealers may be set to improve.
Ian Russell, president and CEO of the Investment Industry Association of Canada (IIAC), says the investment industry at large is facing renewed fragmentation that could see a resurgence in the number of small and mid-size retail dealers.
The expansion of carrying broker services at larger independent dealers facilitates the operations of small firms, Russell wrote in a recent column for Investment Executive. And ongoing structural changes within bank-owned firms may push more financial advisors to seek their fortunes in smaller shops.
Perhaps most important, the Canadian investment business faces the prospect of regulatory reforms that could foster the growth of new, independent firms.
The retail investment business appears to be in relatively good health. Firms’ operating profits have held up this year despite economic turmoil. According to data from the IIAC, profits in the retail segment were up by 25.3% in the second quarter compared with the first quarter, and net profits rose by more than 40.5% as revenue edged higher and expenses declined.
This resilience comes on the heels of several years of strong financial results on the retail side of the investment business. In 2018 and 2019, the retail brokerage channel accounted for 18% of overall industry revenue — levels not seen since the years leading up to the global financial crisis — and the channel’s share of overall industry operating profit is back to pre-2008 levels. Between 2016 and 2019, the retail channel’s profits essentially doubled.
Over this same period, the retail channel’s head count continued to grow, with total employment nearing 15,000 versus less than 12,000 in 2016. Most of that employment growth is at introducing brokers.
Against this backdrop, the investment business is facing initiatives that seek to rein in compliance costs and foster competition — objectives that should create a more fertile environment for new firms, as compliance burdens tend to fall more heavily on them.
A 2018 study from the Federal Reserve Bank of St. Louis examined the effects of scale on compliance costs, concluding that there are significant economies of scale available in compliance. While the study looked at banks rather than at brokerage firms, it found that compliance costs at banks as a proportion of overall expenses were about double for smaller firms compared with larger institutions. Regulatory reforms that aim to reduce compliance costs benefit smaller firms the most, the study concluded.
For the Canadian investment industry, one reform opportunity is to overhaul self-regulatory organizations (SROs). The consultation period for the Canadian Securities Administrators’ (CSA) review of the SRO structure closed on Oct. 23.
While substantive changes to that structure is likely to take some time, SRO reform could significantly alter the operating environment in the investment industry, particularly for small firms.
For example, the Investment Industry Regulatory Organization of Canada (IIROC) estimates that a merger with the Mutual Fund Dealers Association of Canada (MFDA) would generate in excess of $500 million in benefits over 10 years.
An analysis of IIROC’s proposals conducted by Deloitte LLP estimates that while the bulk of the savings would flow to the large dual-platform dealers that dominate the industry, small firms collectively would enjoy tens of millions in cost savings as a result of an IIROC/MFDA merger, and mid-size firms would see around $100 million in savings.
According to Deloitte’s report, the projected benefits of SRO consolidation would come from savings on systems and technology, staffing and other administrative costs. The predicted savings, along with an end to the bifurcation between investment dealers and fund dealers would, in turn, create an easier path for new firms entering the business.
The CSA may favour a IIROC/MFDA merger or the CSA may have a broader overhaul of self-regulation in mind. Such an overhaul could break down barriers for portfolio managers and exempt-market dealers in addition to the regulatory walls between fund dealers and investment dealers.
Either way, the purpose of examining the SRO landscape is to address an array of concerns, including duplication and inefficiencies in the existing system. Assuming policy-makers follow through with reforms, the regulatory environment should become more hospitable to new firms and to increased industry innovation.
The SRO review is taking place alongside the work of the Ontario Capital Markets Modernization Taskforce. The task force is slated to produce its final recommendations by the end of the year, and is contemplating changes such as prohibiting banks from bundling their lending and capital-markets businesses, which currently drives investment business to bank-owned dealers at the expense of independent firms. The task force also is considering requiring bank-owned dealers to open their product shelves to independent investment products and mandating the use of “open data” in the securities industry to facilitate fintech innovation.
In addition, the task force is calling for a single SRO.
At the same time, the Ontario Securities Commission (OSC) has made several changes to regulatory requirements and to its own operations as part of its burden-reduction initiative, which should curb costs for dealers.
The OSC’s changes include streamlining compliance reviews, allowing for more flexible oversight arrangements and providing firms with easier access to information. These measures aim to ease some of the bureaucratic hassles that come with operating an investment dealer and should help small dealers the most.
Reports of the death of the independent investment dealer may have been greatly exaggerated. If policy-makers deliver on promised reforms, independent dealers may soon be staging a comeback.