Citigroup to Flex Muscle in Back Office

The No. 1 financial services firm plans a foray into stock processing.
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Citigroup

(C) - Get Report

is moving into the business of clearing and processing stock trades for small retail brokers and institutions, an event that could reshape Wall Street's back-office landscape.

A move by the financial world's 800-pound gorilla into stock clearing could pose a competitive challenge to the industry's leaders,

Bank of New York

(BK) - Get Report

,

Bear Stearns

(BSC)

,

Fidelity's

National Financial,

Fiserv

(FISV) - Get Report

and relative newcomer

Automated Data Processing

(ADP) - Get Report

. Between them, those five firms process and execute trades for more than 2,100 small brokerages across the country.

Right now, the only stock clearing Citigroup does is for its big Smith Barney brokerage division and a small retail firm. However, that's likely to change in coming months, bank officials say.

Citigroup's jump comes amid sweeping consolidation among clearing houses, with smaller firms either being gobbled up or closing shop. A combination of rising regulatory costs and lackluster trading on Wall Street is squeezing profits for all clearing firms.

But Citigroup, which plans to formally roll out its clearing division sometime next year, believes it has the technology and financial resources to make a big splash in the industry. In advance of its formal debut, the bank has been hiring key employees away from rival firms and recently cosponsored a securities industry event for small brokerages.

"From my point of view, all the consolidation has caused a lot of disruption,'' said Joe Moschella, managing director of Citigroup Correspondent Clearing Services, the bank's newly minted division. "I think what we offer is another choice. A unit that is well-financed.''

Citigroup's return to clearing comes roughly four years after it jettisoned the back-office division it acquired from Schroeder's, the British investment bank Citigroup bought for $2.2 billion in 2000. At the time, Citigroup didn't consider clearing a core business, but the bank's thinking has changed.

Despite the industry's recent struggles, Wall Street clearing operations remain important behind-the-scene players in the operations of hundreds of smaller brokerages -- known as "correspondents" -- that lack the financial resources and back-office muscle to make sure big sales of securities go off smoothly. By relying on a clearing firm to process trades, small brokers can operate without needing to build up enormous capital reserves.

Some on Wall Street say it makes sense for a deep-pocketed bank like Citigroup to get into clearing, given some of its ancillary benefits.

"It's a scale business,'' says Brad Hintz, a brokerage analyst with Bernstein & Co. "It provides a huge box for securities lending."

Securities lending to brokers, traders and hedge funds is a lucrative business. Additionally, opening a clearing operation provides another network for Citigroup to peddle its banking products.

In some respects, Citigroup is following in the footsteps of Bank of New York, which became the biggest player in the clearing industry with its $2 billion acquisition of Pershing from

Credit Suisse First Boston

(CSR)

last year. Pershing clears trades for more than 1,100 brokers and institutional traders.

Citigroup's entry is already fueling lots of acquisition speculation on Wall Street. There are about three dozen clearing firms doing business. Moschella says he "wouldn't rule out" an acquisition, but he adds that Citigroup's current plan is to build its business "slow and steady."

Citigroup may not be the only big change coming to the clearing business. In recent weeks, speculation has been growing on Wall Street that Bear Stearns could try to sell its 340 retail clearing customers and focus on its booming hedge fund prime brokerage business.

Naturally, some see Citigroup as a logical buyer. Speculation about a possible deal between the two Wall Street titans was rampant at a recent Securities Industry Association conference for small brokerages in San Francisco, at which Citigroup clearing executives made a presentation.

To be sure, not everyone is buying the talk about Bear Stearns. Bernstein's Hintz says the firm's retail clearing group is an integral part of its prime brokerage operation and enables Bear to keep its operating costs low. Hintz says it would only make sense for Bear to sell the entire clearing operation, and he doesn't see that happening.

"I don't think Bear can get out of the retail clearing business without it affecting their prime brokerage business," says Hintz. "It's a back-office business that requires many of the same shared systems. Bear has a nice little combination."

Altogether, Bear's clearing operation, which includes the prime brokerage, accounts for 13% of Bear's annual revenue and 17% of its pretax profits, or $165 million over the first six months of the year.

Officials at Bear Stearns and Citigroup wouldn't comment on the speculation. "We don't comment on a market rumor,'' says Citigroup spokesman Brian Steele.

But executives with a number of brokerages, some of whom attended the San Francisco conference, say Bear Stearns is outwardly signaling that it's looking to exit the retail clearing business. They say the firm has declined to renew contracts with some small brokers and has been slow to take on new business.

Fueling the speculation about Bear Stearns is the involvement of its clearing operation in the mutual fund trading scandal. In June, the

Securities and Exchange Commission

notified Bear Stearns that it's considering filing civil charges against the firm because its clearing operation played an important role in processing abusive mutual fund trades for dozens of hedge funds and small brokerages. People familiar with the investigation say Bear not only faces the threat of a fine, but might be forced to make some structural changes in its clearing operation as well.

There's precedent for regulators forcing structural changes in the mutual fund investigation. The brokerage arm of

Bank of America

(BAC) - Get Report

, as part of its settlement pact, agreed to get out of the clearing business. The bank sold the division in June for an undisclosed sum to ADP.