Q&A: Current State of the Cost-Basis Landscape

Bio: Alexander Camargo is an analyst at Celent with the Securities & Investments group and is based in Celent’s New York office. Mr. Camargo’s current research focuses on wealth management technology in North America and in Europe. Mr. Camargo has covered topics extensively on digital strategies for wealth managers, wealth management trends, retail brokerage, financial planning, client reporting, and cost basis regulations/technology. Mr. Camargo’s expertise in behavioral analytics informs his analysis of the retail investor sentiment and trading preferrences. Mr. Camargo has been quoted regularly in the media, including Thomson Reuters, Bloomberg, Dow Jones, Barron’s Wall Street and Technology, Financial Planning and the Financial Times. He has received a B.A. from Yale University, received a post-baccalaureate at Columbia University, and earned a Master’s of Science at City University of New York.

Alex Camargo recently conducted in-depth research surveying the current state of the cost-basis landscape. We’ve taken the time to interview Alex to garner his thoughts on what the findings revealed, as well as his outlook for the cost basis reporting industry.

Q: As this year’s tax season is over, what should firms be doing now when it comes to cost basis?

A: As we’ve just gone through the first year of 1099-B reporting, and with mutual funds coming next, financial firms should be working with their providers to determine ways to increase their operational efficiency. This should not be explicit to just cost basis reporting (CBR) vendors. All parties involved need to ensure that the process runs seamlessly next year. When looking ahead, firms should focus on overcoming any integration challenges they may have faced, as this will be a key component in being successful for the future.

Additionally, firms need to be focused on issues extending beyond complying with the regulations and figuring out what data they’d like to expose to the end customer. There is an opportunity to create a value-add to the investor, as having tax efficient data can help businesses make more informed trading decisions. Looking ahead to next year’s 1099-B reporting, firms need to address any foreseeable challenges with options and fixed income. Do not wait to begin preparing for these changes! CBR vendors and firms should be enhancing their current systems now, not when the final regulations are announced.

Q: What were some lessons learned from Phase II?

A: The most important lesson learned from Phase II was how to best manage investor and client expectations. Effective communication is a key step in the process, and firms who did not do this properly suffered the negative impact. For example, this past year many firms had to send corrected 1099-B statements. This was due to trades from January that triggered a wash sale for December and distributing a corrected 1099-B is a completely necessary and accurate step in the process. This needed to be properly communicated to investors so they understood the entire process and were not alarmed by the corrections. Very few firms did a good job of explaining that corrected 1099-Bs may be the “new normal” going forward.

Q: Your recent research shows the majority of firms decided to use third-party cost basis reporting systems. What drove this?

A: There are many factors that led to this conclusion in my research, but it is clear that the majority of firms chose to leverage the expertise of a third-party CBR system. One of the most consistent points from surveyed executives was that there is a lack of intellectual capital with an in-house system. Being able to create the logic to comply with the regulations takes a lot of time and resource. In both cases, a third-party vendor brings a lot more to the table in terms of awareness and cost basis knowledge.

Q: What makes third-party systems attractive to firms? What specific challenges do vendor solutions address?

A: Third-party systems are attractive to firms because they reduce cost, are flexible, more accurate and come with additional proprietary data. If you don’t have a CBR vendor, you will need collaboration from three different divisions – IT, operations executives and tax specialists. Having a single point of contact for this complex process can ensure a seamless integration, unlike when working with three separate verticals within your firm.

Q: What are the top three most important factors for businesses when choosing a cost basis system?

A: While conducting my research, it was clear that the three most important features firms evaluate when choosing a CBR system is integration, cost and accuracy. When considering a third party, the ideal CBR vendor should have strong understanding of your business model and what type of firm you are. For example, a large institution that has a multitude of accounts needs to ensure that their CBR provider is flexible and scalable. For a more niche broker, the ability to provide value-add tools is probably going to be most important. Remember, it’s not a one-size-fits-all solution. Customization is key.

Q: How does the delay of Phase III impact the industry? How should firms begin preparing for this iteration of the regulation?

A: Having a delay can be a relief to industry participants, but firms are often still skeptical, largely because there is an underlying sentiment that the delay gives the IRS time to reevaluate. In terms of things to consider for Phase III, vendors should be lying down the foundation now and mitigating any sort of errors for the next phase. There was a big learning curve for the first year, but that won’t be the case moving forward. Initially, the industry was in a rush to get a short-term solution in order to meet the regulatory standards. But now, there is an opportunity to create a completely integrated campaign, leveraging your CBR vendor as a long-term solution for your business. If you wait too long, you will miss out on the opportunity to ensure your CBR solution will provide accurate reporting in 2014 with Phase III and beyond.

Q: Have you noticed more firms using cost basis as a revenue generator? What is driving this trend?

A: Many firms are starting to promote the value-add tools they have in order to turn their offering into a revenue generator. Now that we are through the first reporting cycle, there are opportunities to be gained. Through my research, more and more firms showed a willingness to assess their operations to see where CBR can become a value-add for their end clients. Ultimately, these regulations were designed to stop under reporting of capital gains and improve transparency. Cost basis in itself is not a new concept, but with the ability to track data, there is more of an opportunity for tax efficient trading. This is the future of CBR and we will continue to watch it develop over the next tax season.

Q: Were there any findings in your report that came as a surprise to you?

A: I was completely shocked to learn how lenient firms were when it came to grading their current CBR systems. Even with the many hurdles and challenges the industry faced when it came to dealing with these new regulations, they still gave their CBR systems a decent score. Ultimately, this reflects that there was an understanding that this was a new, industry-wide challenge and there was a big learning curve across the board. Going forward, firms expect that data will be accurate and there will be low tolerance for errors.

I also found it interesting that the importance of cost had dropped significantly. Firms are emphasizing the need for seamless integration, and cost as a secondary factor when choosing their CBR system. During Phase I and II, cost was considered equally or more important than all other considerations. Now that many firms have seen that not all CBR systems are created equal, cost has been deprioritized, with accuracy and ease of integration topping the list. It’s clear that the industry is continuing to explore additional ways to leverage these complex systems as the cost basis landscape evolves.

To read a more in-depth analysis of the cost basis reporting landscape, download a complimentary copy of Celent’s latest report here.

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