Financial intermediaries connect market participants with each other and allow them to transfer capital and risk. Major financial intermediaries include banks, mutual funds and hedge funds, dealers, brokers and exchanges, clearinghouses, insurance companies, etc.
Brokers and exchanges
Brokers find out parties who are willing to trade with their clients. Block brokers deal only in large orders. A broker’s job is to get the best deal for its client which is significantly difficult when the order placed by their clients is large.
Investment banks provide advice to their clients in their corporate finance transactions such as the issue of new capital and in mergers and acquisitions.
Exchanges are physical locations that bring together trades so that they can transact. The distinction between brokers and dealers and exchange has blurred recently because exchanges can act as brokers. The distinguishing features of exchanges are the existence of listing regulation and financial disclosures.
The alternative trading system (ATS), (also called the electronic communications network (ECN)) and multilateral trading facilities (MTF) are relatively less-regulated electronic exchanges. Some systems called dark pools are preferred by large traders because they allow them discretion thereby minimizing any adverse price movement due to large trades.
Dealers trade with their clients either on an exchange or through a computerized network. They buy securities when the client wants to sell them and vice versa. They differ from brokers in that brokers do not trade with clients. Some dealers also act as brokers, while some brokers also act as dealers, such financial intermediaries are called broker-dealers. The primary purpose of dealers is to provide liquidity to the market. Primary dealers are dealers who trade with the central bank in the execution of open market operations.
Securitizers issue securities that are backed by a pool of assets such as mortgages, credit card debt, etc. through a process called securitization. Asset-backed securities benefit from diversification, economies of scale in debt services and liquidity. Sometimes a special-purpose vehicle (SPV) is created to which the underlying pool of assets, say mortgages, is transferred, against which the SPV issues securities. Sometimes, asset-backed securities are sliced into different tranches each having different credit risks.
Depository institutions and other financial corporations
Depository institutions include banks, credit unions. They receive deposits from their customers and lend money to companies. Their main advantage lies in the depositors and borrowers’ ability to lend and borrow large sums without entering into direct relationships with each other. It is important that depository institutions are well-capitalized otherwise they have the incentive to lend to risky projects. Other financial institutions include acceptance corporations, discount corporations, factors, etc. They raise money by issuing commercial paper, bonds or common stock, etc. Depository institutions may also securitize some of their loans and issue pass-through securities backed by these loans.
Insurance companies help individuals and companies offset the risks they want to avoid in exchange for a premium. While insurance companies are heavily regulated, credit default swaps (a type of credit insurance) may be issued by less-regulated financial institutions such as investment banks or hedge funds. Insurers are able to offer risk mitigation at a low cost due to diversification. However, they do suffer from fraud, adverse selection, and moral hazard.
Arbitrageurs make a profit from market imperfections. For example, if a stock is traded at different prices in two markets, an arbitrageur would sell the stock in the exchange where it is traded higher and buy it in at the cheaper price thereby earning a riskless profit (this is called pure arbitrage). Together with dealers, they provide liquidity. Even if pure arbitrage does not exist, arbitrageurs use valuation relationships between financial instruments based on the same underlying to identify arbitrage opportunities. They engage in replication, a process in which they create synthetic relationships and transform risk from one form to another.
Settlement and custodial services
A clearinghouse is an exchange that facilitates settlement of contracts. It allows only its members to trade on it, from whom it requires a reserve balance called margin and whose trades and net balance it constantly monitors. All other parties must trade on a clearinghouse through its members. This reduces the counterparty risk involves and improves market liquidity significantly. Clearinghouses guarantee performance in case of future contracts while in other cases, they act as escrow agents. Brokers and dealers also have similar responsibilities when it comes to settlement of trade that they execute.
Depositories or custodians hold securities on behalf of their clients. Broker-dealers also act as custodians in many cases.