Subject 3. Financial Intermediaries

Financial intermediaries are institutions that function as the line of communication between buyers and sellers in the financial system. Functioning as a middleman, a financial intermediary seeks to match investors who have specific financial goals with investments opportunities that can aid in the achievement of those goals.

Brokers, Exchanges, and Alternative Trading Systems

A broker executes trade orders on behalf of a customer. A block broker helps fill larger orders.

Investment banks help their corporate clients raise capital by issuing shares or bonds. They also help their corporate clients identify and acquire other companies.

An exchange is like a market where stocks, bonds, options and futures, and commodities are traded. Most exchanges offer different categories of membership and regulate their members' behavior when trading on the exchange. They also regulate the issuers that list their securities on the exchange.

Alternative trading systems (ATSs) are non-exchange trading venues that bring together buyers and sellers of securities. ATSs do not exercise regulatory authority over their subscribers and do not discipline subscribers other than by exclusion from trading. For example, an electronic communication network (ECN) connects major brokerages and individual traders so that they can trade directly between themselves without having to go through a middleman. Dark pools are ATSs that don't display their orders (which are usually very large).

Dealers

A dealer trades for its own accounts. Individual dealers provide liquidity to investors by trading the securities for themselves. They buy or sell with one client and hope to do the offsetting transaction later with another client.

In practice, most brokerages are in fact broker-dealer firms. That is, as a broker, the brokerage conducts transactions on behalf of clients, and, as a dealer, it trades on its own account.

In the U.S. most broker-dealers must register with the SEC.

Securitizers

Securitization is a structured finance process that distributes risk by aggregating assets in a pool (often by selling assets to a special purpose entity) then issuing new securities backed by the assets and their cash flows. The securities are sold to investors who share the risk and reward from those assets.

In most securitized investment structures, the investors' rights to receive cash flows are divided into "tranches": senior tranche investors lower their risk of default in return for lower interest payments while junior tranche investors assume a higher risk in return for higher interest.

Financial intermediaries securitize many assets, such as mortgages, car loans, credit card receivables, and banks loans.

Depository Institutions and Other Financial Corporations

They accept monetary deposits from savers and investors, and then lend these deposits to borrowers. Both the depositors and borrowers benefit from the services they provide. Depository institutions also provide other services, such as transaction services, credit services, etc.

Insurance Companies

Insurance involves pooling funds from many insured entities (e.g., policyholders) in order to pay for relatively uncommon but severely devastating losses which can occur to these entities. The insured entities are therefore protected from risk for a fee. In other words, risks are transferred from these entities to the insurance company. The insurance company connects customers who want to insure against risks with investors who are willing to bear those risks.

Insurance companies make money in two ways:

  • Through underwriting, the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks;
  • By investing the premiums they collect from insured parties.

Arbitrageurs

Arbitrage is the practice of taking advantage of a price difference between two or more markets (the law of one price). Simply put, it is the possibility of a risk-free profit at zero cost.

Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete.

Arbitrage has the effect of causing prices in different markets to converge.

Settlement and Custodial Services

A clearinghouse is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions.

A clearinghouse stands between two clearing firms (also known as member firms) and its purpose is to reduce the risk of one (or more) clearing firm failing to honor its trade settlement obligations. A clearinghouse reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (a.k.a. margin deposits), by providing independent valuation of trades and collateral, by monitoring the creditworthiness of the clearing firms, and, in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting clearing firm's collateral on deposit.

Depositories or custodians hold securities on behalf of their clients.

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