The last several years have demonstrated an ongoing focus on transparency driven by guidance and rules from the governing bodies of the mutual fund industry.  To date, most transparency initiatives have focused on Dealer to consumer transparency (404a and 408b2) and Dealer to Fund transparency that support a myriad of requirements from “Distribution in Guise” prospectus rule compliance including Rule 22c-2. The Department of Labor proposal reveals a new requirement on the horizon for increasing dealer transparency into the DOL’s fee and fiduciary requirements. So why has this become of interest to the DOL now? To understand this drive requires looking at the dealer infrastructure.

Historical Point of Reduced Visibility

Dealers have long used custodians and clearing partners in the industry to outsource core, commoditized back office functions so that they can focus on their business value propositions to their end clients.  These custodians and clearing partners have participated in revenue sharing since the first revenue sharing contract was drafted, to offset the cost of the service. The Clearing Partner also provides the critical function of support of a supermarket of funds for the executing dealer to choose from without the cost of executing and maintaining hundreds of contracts with fund companies.  This ecosystem is a well-oiled machine; consequently, today, trade breaks, account imbalances and other woes of yester-year are largely a thing of the past.   Transparency was not a requirement to meet the core value of these services and therefore was not baked in from day one.

Why is this Something that has to Change?

Technical integration requirements are quite low for executing dealers to utilize these clearing services. Perhaps an oversimplification, but Clearing Services generally need the executing dealer’s trade file and contact information for dealing with breaks and settlement account numbers.  Trades are communicated, confirmation files are returned, and an orderly — if not automated — process to reconcile takes place.  Mutual fund distribution fees collected on behalf of the executing dealer by the clearing partner are not transparent and are strictly handled by the clearing partner.  These fees historically have been held close to the vest for the obvious competitive pricing reasons.

New rules however with the DOL proposal require executing dealers to further attest to and disclose fees to their clients. The fact that executing dealers must account for their accuracy has placed a new requirement on these operational relationships.  One that is not going to be easy to address in the current Super-omnibus clearing environment when all that is exchanged today are trade files, confirm files and a lump payment that represents fees collected if any revenue was left after the service provider netted their cost. The current method of fee collection, haircut, and flow through payment has a lack of transparency that will have trouble supporting the disclosure requirements of the DOL.

What are We Needing to Support Going Forward?

We are all aware that once trades are rolled up Omnibus, a certain opacity to the account is one of the major trade-offs to the operational efficiency gained that reduce cost, trade rejects and improve billing efficiency. This opaque nature, as mentioned above, has been a major issue for Funds to overcome in their effort to adhere to prospectus compliance rules, distribution in guise rules and mandates like 22c-2.  The shoe is falling from the other foot as we speak.  Executing brokers, TPAs, and Record Keepers now have the need for more transparency into the fees and accounting of their custody and clearing partners.  Some of the items we believe will have to be accounted for are:

  • Whether rules adhered to by the executing dealer with regards to fee waivers, share class eligibility and meeting prospectus rules are maintained once rolled up super omnibus by their clearing partners.
  • Are all fees accounted for and reportable at the granularity needed in the supply chain of services that the end client received?
  • Were all fees calculated accurately based on the nature of the relationship as stated to their clients that they now carry a fiduciary responsibility for?


What are the Potential Off the Shelf Solutions?

The mutual fund industry already has all the tools necessary to remediate these issues. Tried and true business process and technology utilized by self-clearing brokers, bank trusts and custodians can be brought to bear to address, track and report on activity and positions in support of the new DOL rules.  The executing dealer’s need to track specific activities of the custodian and clearing partner may sound like a major operational burden, but trading systems have come a long way in the last decade from an operational efficiency and cost to implement context.   These systems core features that include revenue management tracking and reporting capabilities are fully automated and require a shockingly small operational crew to maintain.  These systems benefit the dealer in multiple ways, beyond providing the tools to adhere to DOL rules.  When the amount of data management, reporting and control points are assessed in full to meet DOL requirements in this area, the move to put a trading system already structured to fit these needs in between the books and records and your custody and clearing partners becomes a solid option.

Written by: Whitfield Athey, CEO, Delta Data

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