45.d: Financial intermediaries and their functions
Financial intermediaries act as a conduit between buyers and sellers in financial markets and help firms and intermediaries achieve their financial goals. Brokers and exchanges, investment banks, dealers etc. are examples of financial intermediaries.
• Brokers, Exchanges, and Alternative trading systems
– Brokers find counterparties for their clients' buy or sell orders. They may find clients personally or use computer systems to find potential trades. Block brokers work for large traders. A large buy order pushes up the market price of the security while a large sell order pushes the security price down. Block broker has to manage the trader’s expectations while at the same time he has to offer price arbitrage for other traders to participate in order filling
– Investment banks provide advisory services to their clients (mostly firms) on fundraising through initial or seasoned securities offerings. Their corporate finance divisions help companies issue common/preferred stocks, notes, bonds etc and give advice on potential mergers and acquisitions.
– Exchanges are the platform on which traders meet and negotiate their orders. With the advent of electronic matching systems, exchanges are playing the role of brokers. NYSE, Nikkei, DAX are some of the popular exchanges. Exchanges work under regulatory conditions, which differentiate them from brokers. Exchanges require issuers to list their securities on the exchange and publish regular financial disclosure, which helps in price discovery of securities. They may also require listed firms to adhere to other requirements like minority shareholder’s rights, insider-trading disclosure etc.
– Alternative trading systems (ATS) also known as Electronic Communication Networks (ECNs) or multilateral trading facilities (MTFs) have similar functions as exchanges except that they don’t exercise regulatory authority over subscribers (other than trading conduct). Some ATS are called dark pools as they don’t display all the orders placed on them and are preferred by some investment managers as they don’t want to expose their positions to other traders who can tray to take advantage. Examples of ATS include BATS (US), Pure Trading (Canada), Turquoise (Europe).
• Dealers fulfill their client’s orders by acting as a counterparty to their trades. They buy/sell from their clients and try to reverse the transaction by finding another client. Dealers create liquidity in the system. Liquidity is the ease with which traders can settle their trades. Higher liquidity lowers transaction costs while low liquidity raises the cost. Goldman Sachs, Nomura, Deutsche Bank are some of the large dealers. Some dealers also act as brokers and are referred to as broker-dealers. Broker-dealers may face a conflict of interest at as broker they have to get the best price for the client which as a dealer they have to think of their own profit when they settle the trade with another client. Primary dealers are dealers with whom central banks trade when conducting monetary policies.
• Securitizers create a pool from a large number of securities or assets and then sell securities representing a stake in the pool to investors. For e.g. Mortgage Backed Securities (MBS) are created by pooling several residential mortgages. The payment to investors in the pool came from the principal and interest payments that the original borrowers paid. Securitization helps in enhancing the liquidity of securities which otherwise can be very illiquid and helps in reducing the funding cost for the asset/securities in the pool. Financial intermediaries involved in securitization can set up a special purpose vehicle (SPV) or special purpose enterprise (SPE) to transfer the default risk to separate balance sheets.
Securitizers also create several classes of securities, called tranches with different rights to cash flows from asset pools. While senior tranches have the lowest risk of receiving cash flows, junior tranches face the highest risk.
• Depository institutions and other financial corporations such as commercial banks, savings, and loan banks, credit unions take deposits from savers/investors and lend the money to borrowers. The depositors in return get an interest on their deposits and other transaction services from the banks such as cheque writing.
Acceptance corporations, discount corporations, and payday advance also provide credit to clients but with money secured by assets such as consumer loans, machinery, account receivables etc.
Brokers also provide credit to investors who want to buy securities using the money other clients have put in their accounts.
Equity stakeholders in banks, brokers and other financial institutions that provide credit keep a check on the lending done as in the case of defaults the losses are covered by equity capital.
• Insurance companies provide financial cover to individuals/firms in case of an unwanted emergency like accident, illness, death, fire, loss of property, equipment etc. These companies collect premiums in return for this cover. Insurance companies try to minimize their risk by diversifying their portfolio. They have to deal with three key risks: a) Fraud which means misrepresenting facts to falsely claim insurance benefits, b) Moral hazard when people take more risk due to insurance cover than they would in absence of it, and c) Adverse selection when the company selects greater number of clients who are more at risk. Insurance companies try to minimize their risks by insuring their positions with reinsurance companies.
• Arbitrageurs look for price disconnect between prices of similar/identical securities in different markets. They act as financial intermediaries as they end up connecting buyers in one market to sellers in another market. In its purest form, an arbitrageur will look to buy and sell the same instrument in different markets. Arbitrage opportunities are generally rare in well-functioning markets. Arbitragers differ from dealers as they look for buyers/sellers in two different markets at the same time while dealers look for buyers/sellers in the same markets at different times.
• Clearinghouses and Custodians
– Clearinghouses settle trades. They also minimize counterparty risk, the risk that one of the two parties doesn’t fulfill its obligations, through – a) escrow services i.e. transferring securities and money from/to buyer/seller, b) ensuring member traders have adequate capital and post performance bonds, c) limiting the aggregate net trading quantities (buy minus sell) that member can settle, and d) guaranteeing contract performance in futures markets.
– Custodians hold securities on behalf their clients and ensure the preservation of securities by protecting them against frauds, natural disaster or oversight. Banks generally provide custodian services.
Check your concepts:
(45.11) Which of the following is the most distinguishing feature between exchanges and brokers?
(a) Electronic order matching systems
(b) Regulatory operations
(c) Place of trading
(45.12) Which of the following statements is least accurate about the block brokers?
(a) They provide price concessions to encourage other traders to trade with the large traders
(b) A large buy order generally will trade at a premium to the current market price
(c) A large sell order generally will trade at a premium to the current market price
(45.13) A financial intermediary tries to sell to their customers at high prices and buys from them at low prices. The financial intermediary is most likely to be a:
(a) Broker
(b) Dealer
(c) Investment bank
(45.14) A firm takes an insurance for fire. After taking the insurance, the firm does not follow proper checks and balances to stop the fire. This risk faced by the insurance company is most likely to be classified as:
(a) Moral Hazard
(b) Adverse Selection
(c) Fraud
Solutions:
(45.11) Correct Answer is B: The exchanges and the brokers are most distinguished by their regulatory operations.
(45.12) Correct Answer is C: Block brokers provide the concessions to the other traders to trade with the large traders. So, for a large sell order, they have to sell at a lower price to provide the concession.
(45.13) Correct Answer is B: A broker seeks the best execution price for the client. A dealer wants to maximize his profit by charging the high bid-ask spread. So, he would want to sell at the high prices and buy at the low prices from the customers.
(45.14) Correct Answer is A: When people are less careful about avoiding the losses after insurance than otherwise, then that leads to moral hazard.
Exam Alert: Candidates should be very comfortable with the function of all the intermediaries and how the intermediaries differ with respect to each other for providing similar services. For example- dealers and brokers for execution; dealers and arbitrageurs for providing liquidity.
