Broker Dealer Software Stack
What software broker dealers use
Welcome to the post #2.
Last week was rich with events in fintech:
Plaid’s deal fell apart, but the general opinion about Plaid is positive,
Affirm’s IPO let the company raise 1.2B,
A few fintech startups closed significant rounds - LendingPoint raised $125M, Rapyd and MX each got $300M injection, Rho also received $15M as a part of Series A and more.
The most interesting trend that I’ve noticed in fintech so far is the demand in the infrastructure B2B businesses. Empire Startups streamed the second part of Fintech Investor Series and the question of B2B startups was discussed in details and also Charley Ma raised the question about end-to-end banking software stack and landscape:
Before joining Refinitiv, I’ve spent a few years working at a startup that was building solutions in the brokerage field - or in fact performed as a broker dealer. I was going through all of my notes, spoke to a few colleagues and friends who know that field in and out and wrote this post about Brokerage Software Stack.
If you’re interested in knowing what happens when you buy and sell stocks in your perfectly designed mobile application, or interested in how, for example, robo-advisors work, or keen to understand the business of broker dealers and how many companies & solutions this business interacts with - this post will uncover some of it.
To make this post easier to digest, I split it into several parts that will walk you through the overall experience as a user. I will also give examples of what companies work on each and every part of this process.
TL;DR
Part I: Onboarding
When you open a new account at a broker dealer, you need to fill out the application form. Client onboarding for fintech is a highly regulated field due to compliance and risk management procedures. Most companies build their proprietary application forms based on what clearing firm requires (we’ll talk about clearing firms later), some use third party software.
Appway and Pega are a couple of platforms providing the seamless onboarding experience. This onboarding experience is tied up with KYC (Know Your Customer) and AML (anti money laundering) procedures. There’s a ton of companies in this space, you can read about some of the notable startups here: https://builtin.com/fintech/regtech-companies.
When your application is given a green light, the account is going to get opened. If the broker dealer is a self-cleared entity, then the account is going to be opened within its own back office. In case the entity is not self-cleared, then the broker dealer opens an account in its clearing house and simultaneously opens an account in its own back office (let’s say middle office in this case).
A few words about clearing firms - it’s an entity that controls all the transactions for the broker dealer, including cash transactions, equity settlement and more. You can think of a clearing firm as a back office for the broker dealer. The most popular and widely used by a lot of new startups in this field is Apex Corporation. There are a few reasons why Apex is the most popular software - APIs, streamlined process of onboarding. Robinhood, before becoming a self-cleared entity, used Apex Corporation. This is why you received all the statements and tax documents from Apex a few years back.
Part II: Cash Management
When the account is open and you’re about to start trading, you need to deposit funds. Here we also need to remember whether the broker dealer is self cleared or not. If the latter - all cash management operations occur on the clearing firm side. Clearing firm has a custodian contract with a particular bank and manages the incoming funds accordingly. In case the company is self cleared, then such transactions go through the bank that this broker dealer has a contract with.
There’re plenty of banks that offer custodian services. Clearing firm always has cash management and settlement services as a part of their plan.
One thing that should be mentioned here is how the funds are moving around. Obviously as a client you need to connect your bank account. This usually happens via one of the software companies like Plaid to get the client’s bank account credentials and do the preliminary verifications. Some broker dealers require you to manually enter your bank account credentials.
As soon as the bank account is connected, most likely ACH, but sometimes wire transfer is initiated. I won’t go into payment details, when the transfer goes through the funds hit your custodian bank, changes are reflected on the clearing firm side and therefore you see all the details on your brokerage account.
Part III: Trading
Trading is a big part of the process with a lot of small pieces. One, that is the most important - order management system, or OMS. For some agency model businesses, like broker dealers that used to call their clients by phone and submit the deals to particular routes, they might not even have the UIs or client facing applications. And in fact their OMS is just a set of validation rules that they go through manually.
OMS is where the pre-trade validation goes. Before your order is placed and routed to a particular exchange or market maker, the broker dealer needs to pass certain tests that are regulated under the Market Access Rule. This process is usually integrated within OMS, sometimes it does not let you place orders, so verification happens on the fly. Sometimes it tries to submit the trade, but the backend returns an error because the order did not pass the MAR.
The core mission of OMS is to pass the order to the appropriate route. Routes can be different:
you can place the trade directly into the exchange,
you may submit an order to the market maker - this is the model that Robinhood and others are using, because market makers pay broker dealers for the deal flow,
you may also have access to the dark pools and more
If you want to dig into how the orders are routed, you can read more about the Smart Order Router - it is a whole concept of how and where trading orders can be transferred. There’re a few players that provide that smart order routing to broker dealers as a software.
Bonus
There’s another part that I need to mention. Before the trading starts each day the broker dealer receives the information from the clearing firm about the positions or each client. Clearing firm maintains the trade book, settles the trades and works with its custodian bank to provide the most relevant and up-to-date information about the client’s account.
When the market closes, broker dealers also have to sync up with the clearing firm to reflect the right positions in the portfolio and make sure there are no discrepancies.
This may sound very simple, but in fact it’s a complicated process due to corporate events, such as splits, dividends, any account actions and more - all of these events affect the client’s balance and positions. The margin of error is low, but it exists - such sync-ups between broker dealer and clearing firm are absolutely necessary.
Part IV: Compliance
This part is where it gets complicated. As you can imagine, the broker dealer has to go through a lot of legal procedures, and it happens on a daily basis. Broker dealers have to submit all kinds of reports, like OATS, CAT and other to FINRA. You can find a few software solutions that help with this part, like SS&C and n-Tier.
Another important piece of the compliance part is the post trade analysis - systems that check the trades for spoofing, layering and other fraudulent techniques that are restricted by FINRA and SEC.
Part V: Market data and Reporting
Market data is probably something that comes to mind first when you think about the broker dealer business. There’s a big list of market data providers, some broker dealers combine several different sources to provide their clients an access to the most advanced data.
I personally think that reporting is still one of those untapped areas of this business. When we say reporting, it has a few core parts, but not limited to:
Trade confirmations
Statements
Tax reports
Investor relations documents - shareholder meetings, votes
There’s a separate company for each type of the reporting activity. From one side - you can barely find any company with modern infrastructure, at least a simple API, which means that opportunity exists. From the other side - every broker dealer and wealth management company is such a monolithic thing, when the business is set up - it becomes close to impossible to replace the existing vendors.
Hence you can see small companies doing the following:
Get the information from the bank, broker dealer and / or clearing firm
Create a nice pdf form
Send it back to the broker dealer or the client directly
This is the case, again, for each document type. So tax reports are generated and distributed by one company, investor relations documents by the other company and so on. Hence setting up a new broker dealer is a long tedious process and partially because of a lot of platforms you have to integrate with while most of those integrations are not self-served and broker dealers have to really build some sort of communication channel between the reporting provider and its own back office.
Part VI: Risk Management
Risk management is helping the broker dealer to manage and mitigate such risks as margin calls and money management, compliance risks and more. This matters the most for any asset class or trading activity. The broker dealer performs various trade analysis mechanics - pre trade, at trade and post trade.
The most complicated part of trade analysis comes with more complex asset classes like options or other derivatives. This is the main reason why some of the broker dealers do not let their clients use multiple leg option strategies - it’s too difficult to calculate the risks and reflect the real trade value, account balances and risks.
Summary
Broker dealer software stack is very segmented - there are a lot of companies that have been in the market for over 15 years, some are moving fast, creating APIs and more, some are fine with what they have. There’s a big barrier in this industry for new market entrants since the infrastructure is usually a big and monolithic thing and a new broker dealer has to build a very strong case.
Disclaimer
One important note: some of the companies, like Refinitiv (where I work as a PM), are a lot more than just market data providers and usually have a variety of different products for trading, wealth management, order routing and more. I wanted to mention companies not more than 2 times in the map.
If you have any feedback or want me to write about something important in fintech - ping me on twitter.
Best,
Max