Broker-Dealer Industry Re-energized Amidst Uncertain Regulatory Environment

FIDELITY CLEARING & CUSTODY SOLUTIONS Broker-Dealer Industry Re-energized Amidst Uncertain Regulatory Environment The broker-dealer (BD) industry finds itself at an inflection point as it continues to evolve with the specter of sweeping regulations and changing investor needs. The situation will no doubt cause continued evolution in this business. Against that backdrop, Fidelity Clearing & Custody Solutions (FCCS) hosted a roundtable event for a group of nine leaders from BD firms in November 2017. Participants shared learnings and business impacts related to the delay of the Department of Labor (DOL) Fiduciary Rule. The discussion followed a recent FCCS survey, Managing the Evolution of the Investment Product Landscape, which assessed how the current regulatory environment is affecting the product landscape. The goal of the roundtable was to facilitate peer-to-peer learning and networking. It evaluated the opportunities and challenges that firms are encountering. Key themes that arose at the discussion included the BD identity crisis, industry consolidation and mergers and acquisitions (M&A), recruiting, technology and the impact of the regulatory environment on an evolving product shelf. What's inside Re-Energizing the Broker-Dealer Segment M&A/ Consolidation Recruiting and Retention Keeping Pace in Technology Looking Ahead Additional Resources 1

Re-Energizing the Broker-Dealer Segment Perhaps the most intriguing nugget which emerged during the roundtable was the idea that many traditional broker-dealers characterize themselves as sophisticated, innovative technology and service organizations. There are now healthy discussions around whether the name "Broker-Dealer" accurately represents what these transformational firms are really doing and the value they truly provide. These future-ready firms are arming themselves with the latest technology solutions, helping their advisors grow and transform their business via robust practice management programs, and helping them navigate through complex regulatory changes. The firms are staying ahead of the curve by anticipating change, which is occurring at an increasingly rapid pace, in order to meet client needs. A SHIFT TO FEE-BASED BUSINESS AND POTENTIAL BARRING OF NEW MUTUAL-FUND DIRECT BUSINESS ANTICIPATION OF THE SEC ESTABLISHING A FIDUCIARY STANDARD TO ALL ACCOUNTS 2 It became clear over the course of the discussion that firms had already been evaluating their product strategies and pricing plans for 18 months, despite the delay in the DOL Fiduciary Rule. Data from the Managing the Evolution of the Investment Product Landscape survey supports this line of thinking, with 75% of firms reporting a shift in strategy or investment product offerings since June 2017 2. The consensus was that the proverbial horse is out of the barn, and regardless of what the next wave of regulation is called, it will focus on the fiduciary standard. Survey respondents agreed, with 93% anticipating that the Securities and Exchange Commission (SEC) will establish some form of uniform fiduciary standard in the future. 81% 12% 5% 2% As a result, fee-based business continues to capture the bulk of flows and revenue. One roundtable participant communicated that feebased business accounted for 100% of their revenue growth over the past four years. In the Survey, 57% of firms expected the majority of their retirement business would be fee-based as opposed to commission-based by 2020, a figure which roundtable participants viewed as low. Yes, in the next 12 months Yes, but it will take more than a year to be issued No Other Nearly all firms anticipate the SEC will establish a fiduciary standard at some point in the future. 2. Fidelity Survey, Managing the Evolution of the Investment Product Landscape. Quantitative, online survey representing 38% of 157 survey participants within FCCS B/D & Bank Clearing clients fielded October 25 through November 15th, 2017. 2

AVERAGE FIRM ASSETS UNDER MANAGEMENT 3 RETIREMENT ASSETS BREAKDOWN Current NON-RETIREMENT ASSETS BREAKDOWN Current 45% 55% 42% 58% Fee-based AUM Commission-based AUM Fee-based AUM Commission-based AUM 57% 43% 51% 49% Estimate in two years Estimate in two years Firms estimate that the majority of their books will shift from being commission-based to fee-based by 2020. Survey data also indicated that 62% of firms were either already limiting product shelves to support compliance with various regulations or were considering doing so. As the roundtable discussion turned to mutual-fund direct (MFD) business, one participant revealed that they have reduced direct business by 80%. Nearly a third of respondents in the Survey 3 are planning a change in their strategies for MFD and a mixed sentiment existed among both respondents and roundtable participants toward limiting new MFD business versus outright barring it. In terms of current MFD business, half of the brokerdealers who responded in the Survey 3 plan on grandfathering those funds, with the other half either charging fees or moving these assets. During the discussion at the roundtable, panelists indicated that they oftentimes underestimate the cost of supporting MFD in the current regulatory environment. HAVE YOU OR DO YOU PLAN ON CHANGING YOUR STRATEGY REGARDING THE FOLLOWING DIRECT-HELD BUSINESS? 3 DIRECT-HELD MUTUAL-FUNDS Yes 30% No 52% Do not know/unsure 18% 3. Fidelity Survey, Managing the Evolution of the Investment Product Landscape. 3

The discussion on usage of the next generation of mutual fund share classes generated a lot of buzz with the roundtable participants. Class T shares, modified class A shares, and mutual fund clean shares, were all discussed. Across both the roundtable participants and Survey respondents, there was a difference in opinion on how firms defined a clean share with inconsistencies on if it should/could include a sub-ta fee, or not. Furthermore, the term clean share itself was not well accepted and some have taken to calling them wholesale shares. HOW FIRMS DEFINE A CLEAN SHARE STRUCTURE 4 (Among those planning to offer Mutual fund Clean Shares for commission-based retirement business) 45% 45% 10% No sales charge, no 12b-1 fee and no shareholder service fee/sub TA fee No sales charge, no 12b-1 fee, but may have a shareholder service fee/sub TA fee Others Given the array of share classes available by mutual fund firms, over 40% of Survey respondents4 indicated they are not planning to offer shares without a sub-ta payment, nor class T or modified class A shares. Most firms indicated they are comfortable defining clean/wholesale shares with a sub-ta fee. Further, without a full array of shares currently on the market with no shareholder servicing fees nor distribution expense, the sentiment at the roundtable was that broker-dealers and their advisors may not be able to meet client investment objectives due to the paucity of options. 4. Fidelity Survey, Managing the Evolution of the Investment Product Landscape. 4

M&A/ Consolidation M&A activity remained strong, with 109 transactions representing $265.5B in assets in 2017. While independent broker-dealer (IBD) transactions were fewer, with only five in 2017, they occupy a more concentrated sector of the wealth management space. Those five large transactions totaled a combined $165.9B, more than one and a half times the total RIA M&A transaction assets in Fidelity s 2017 M&A Wealth Management Transaction Report 5. As it pertains to IBDs, roundtable participants mulled the forces driving M&A and consolidation. M&A ultimately lets IBDs add scale and improves profitability. There was also optimism that these can lead to enhancements in advisor technologies, increasing the value proposition. RIA transactions comprised 95% of the transactions and declined slightly to 104 transactions from 2016 s 108, but saw assets increase from $68.5B to $99.6B 5. It is also worth noting that the deals were larger in 2017: RIA transactions in 2017 totaled $99.6B, up 45% from $68.5B in 2016. Strategic Acquirers and Wealth Management RIAs completed more than 80% of transactions in 2017 (45 and 40, respectively), up from 67% in 2016 (38 and 34, respectively). Banks became more active acquirers, completing 14 transactions, representing more than $17B: First Republic completed five transactions. Buyers are active, well capitalized and continuing to create new business and ownership models. New sources of capital including more private equity firms behind many of the transactions in 2017 fuel activity, deal size and emerging business models. The wealth management industry steadily converges into larger national and regional branded players. All these factors, combined with the confidence conveyed by participants in Fidelity s December 2017 M&A Leaders Forum, suggest that the wealth management industry will continue to see strong levels of M&A activity in 2018. Assets # of transactions Total $265.5B 109 IBD $165.9B In 2017, the industry continued to see healthy M&A activity, with 109 transactions representing $265.5B in assets. There were just 5 IBD deals, but these represented $165.9B, or more than 50% of assets 5. 5 CIBC purchased Atlantic Trust for $8.4B 5. 5. 2017 Fidelity Wealth Management M&A Report. Fidelity compiled the data for this report from public information. Data for this report covers the period from January 1 December 31, 2017. In December 2016 and December 2015, Fidelity tracked 11 and 10 transactions, respectively. Note: those numbers do not include transactions involving independent broker-dealers 5

Recruiting and Retention Keeping Pace in Technology Recruiting and retaining talent was of major concern to roundtable participants, as both young and entrepreneurial advisors and older advisors pose a dual threat to broker-dealers. With Baby Boomer advisors exiting the industry and Gen X & Y advisors raising the bar by demanding modern technology solutions for themselves and their clients while potentially seeking to start their own businesses, firms are concerned. Culture, flexibility and advisor training are increasing in importance. Therefore, firms are acting more like boutiques, in terms of offering both scale and personal support. This will also aid in fee-based business becoming an increasingly important part of the value proposition. As evidence, Cerulli s 2016 U.S. Broker/Dealer Marketplace Report states that the top 10 IBD firms have roughly half of the advisors in the country (48%) due to a strong value proposition. 39% 48% 2005 2015 Source: Cerulli 2016 U.S. Broker/Dealer Marketplace Report 6. The 2017 Fidelity Investor Insights Study (a.k.a. The 2017 Fidelity Millionaire Outlook Study) was conducted in two phases. The first was an online, blind study conducted during the period January 18th through February 13th, 2017. It involved a total of 1,367 20-minute (on average) online interviews, with the sample provided by TNS, a third-party research firm not affiliated with Fidelity. The study was focused on understanding affluent investors attitudes, goals, behaviors and preferences related to investing, wealth management, and advice. Target sample included respondents across affluence levels, from $50,000 to more than $10 million in total investable assets, excluding any real estate or investments in 401(k), 403(b), pensions, or other employer-sponsored retirement plans. Millionaires are defined as those with $1 million or more in total investable assets with the same exclusions just mentioned, which included 601 participants. The second phase exploredthe topic of the value of advice via a series of qualitative focus groups conducted with 51 investors in 3 geographically diverse locations (San Francisco, Chicago, and Boston). Participants were Affluent Boomer investors (52-70 years old, $1M+ in investable and/or retirement plan assets) or High-Earning Gen X/Y investors (25-51 years old, HH incomes of $250K+ if married, or $150K+ if single and/or $1M+ in investable and /or retirement plan assets). Participants also represented a mix of both advice and non-advice users. Today s competitive landscape mandates that businesses be able to pivot strategies and, in some instances, products, as disruption and change spoil planning. Roundtable participants recognized that competition is borne not always from other firms. Sometimes, the roundtable participants noted, a client s latest positive experience with technology directly impacts decisions to ditch an archaic legacy system in favor of the latest platform. To be a future-ready firm means keeping up and scaling technology. Keeping up with the lightning fast changes in technology can be difficult for brokerdealers to handle on their own, and are costly both from a human capital and monetary perspective. Roundtable participants noted the conundrum facing the industry, the need for a turnkey solution while evaluating what will make their advisors more productive and their clients more content. This is overlayed with the difficulty in recruiting against competing systems and preferences. The ultimate reason to outsource is to ensure you are getting best of breed technology, as well as to satisfy the demands of the tech savvy clients, including millennials, generations who are driving the wealth shift from Boomers to Millennials and Gen X/Y 6. Fidelity s 2017 Millionaire Outlook Study indicated that 53% of Gen X & Y millionaires would find a new advisor if their current advisor was not using the latest technology to service their accounts 6. Some consider the use of technology for collaboration as a top 3 factor in choosing an advisor. Gen X/Y 53% Baby Boomers+ 29% More Gen X/Y millionaires said they would find a new advisor if theirs were not using technology to enhance services. Gen X/Y 23% Baby Boomers+ 2% 6

Looking Ahead Additional Resources Leading BD firms are bringing new energy to the industry. They are investing in robust technology and providing enhanced offerings, particularly within managed or discretionary accounts. They also have strong value propositions, are actively recruiting to grow their talent pool, and are focusing on strengthening their brand. The bestin-class firms are growing and adapting to the changing world around them and will continue their journey on the growth path. The resources listed below are available through Fidelity Clearing and Custody Solutions client resource center and public website. CONSOLIDATION WILL CONTINUE TO ACCELERATE, CREATING WINNERS AND LOSERS Sanjiv Mirchandani, President, Fidelity Clearing & Custody Solutions, shares predictions for the future of the wealth management industry. FIDELITY 2017 WEALTH MANAGEMENT M&A TRANSACTION REPORT M&A activity among RIAs and Independent Broker- Dealers for 2017 RECRUITING REDEFINED: PERSPECTIVES ON THE LOOMING ADVISOR TALENT SHORTAGE Recent Fidelity research shows that firms need to re-focus, re-position, and re-engage to attract young financial advisors. SETTING THE PACE: HOW eadvisors ELEVATE THE CLIENT JOURNEY AND OUTPERFORM PEERS A fresh look at eadvisors finds that they continue to leverage technology to spur productivity and enrich the client experience. NAVIGATING REGULATORY CHANGE THROUGH A STRONG CULTURE OF COMPLIANCE WHITE PAPER Learn how firms have embraced a culture of compliance as a way to meet existing regulatory obligations and position their firms to manage new requirements. WEALTHSCAPE: THE GATEWAY TO YOUR TOTAL ADVISOR PLATFORM Fidelity's next-generation technology centers on an enhanced workstation, helping you digitize, improve productivity and collaboration, and focus on what drives value to clients. go.fidelity.com/wealthscape 7

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