Financial intermediaries and the services they sell

Who finds the other side of a trade?

Brokers, exchanges and their cousins act as agents: they bring buyers and sellers together without trading themselves. Dealers and arbitrageurs do take the other side, which makes them principals.

Intermediary	What it does	Takes on the trade itself?
broker	Finds a counterparty for a client’s order and earns a commission	No (agent)
block brokers	Handle very large orders carefully, so the price does not move	No
investment banks	Advise on and arrange issuance (initial public offerings, or IPOs, and seasoned offerings) and mergers	Sometimes underwrite
exchange	Provides a venue and rules for trading, and often regulates members and listed issuers	No
alternative trading systems (electronic communication networks or ECNs, multilateral trading facilities, dark pools)	A trading venue without exchange-style regulatory power over subscribers	No
dealers	Buy and sell from their own inventory and earn the bid–ask spread	Yes (principal)
broker–dealer	Does both	Both
arbitrageurs	Buy in one market and sell the same or an equivalent risk in another	Yes, briefly

Financial intermediariesa match, liquidity, a repackaged claim or a settlement promise

• A match (agent, does not trade) Memorize
  • Broker finds a counterparty, earns commission
  • Block broker places very large orders without moving price
  • Exchange and ATS venue and rules; exchanges also regulate members
  • Investment bank advises on and arranges issuance and mergers
• Liquidity (principal, takes the other side) Memorize
  • Dealer own inventory, earns the bid–ask spread, moves liquidity through time
  • Arbitrageur same or equivalent risk, two markets, moves liquidity across markets
• A repackaged claim Use it
  • Securitizer pool of loans into an SPV, sells tranches
  • Depository institution deposits in, loans out
  • Insurance company pools many uncorrelated risks
• A settlement promise Memorize
  • Clearinghouse settles; in futures guarantees both sides
  • Custodian or depository holds assets, protects against loss

A dealer’s service is liquidity. A client who wants to sell at 10:00 does not have to wait for a buyer who shows up at 14:00: the dealer buys now and carries the position until that buyer appears. An arbitrageur solves a different gap. The seller is in Frankfurt and the buyer is in London at the same moment, and the arbitrageur trades with both. Think of the dealer as bridging a gap in time and the arbitrageur as bridging a gap in place.

Arbitrageurs also work with instruments that are different but related. A trader who sells an index futures contract and buys every share in the index holds almost no net risk, because the two legs move together. Building one position out of others like this is called replication. It lets arbitrageurs supply a contract when buyers want more of it, or absorb it when there are too many, and it keeps related prices in line.

A broker–dealer has a built-in conflict. As a broker it must seek the best price for the client. As a dealer it earns most by selling high to clients or buying low from them. Clients can limit the conflict by specifying how an order is filled or by using a pure agency broker.

Exam tip Ask “who is on the other side?”. An agent is never the other side. A principal always is.

Go deeper Why dealers' spreads widen when inventory or information risk rises

A dealer who holds shares can lose money if the price falls before the shares are sold. The spread pays for that risk. It widens in volatile markets, in thin markets where inventory takes longer to sell, and when the dealer fears the client knows something it does not. In each case the dealer is asking for more compensation for the risk of being the other side.

Who repackages and pools?

Securitizers, banks and insurers sell a different service: they turn assets or risks into forms that suit more investors.

securitizers buy assets such as mortgages or car loans, place them in a special purpose vehicle and sell claims on the pool, often in tranches with different rights to the cash flows. Investors get a diversified, easier-to-price and more liquid claim, and the originator can recycle its capital into new loans. A separate vehicle also protects investors if the sponsoring bank fails. The Fixed Income topic covers securitization in full.

depository institutions (banks, credit unions) take deposits and make loans. Depositors earn a return without contracting with borrowers, and borrowers find funds without searching for investors. The bank screens and monitors borrowers so savers do not have to. Other lenders such as finance and leasing companies do the same with funds raised from bonds and commercial paper, and brokers lend to clients who buy on margin.

insurance companies sell a payment if a loss occurs, such as fire, auto or life cover. A large pool of policies whose losses are not closely linked makes the total loss rate predictable, so the risk is cheap to carry. Insurers must still manage fraud, moral hazard (people take less care once insured) and adverse selection (the most at-risk people are most likely to buy).

Go deeper Moral hazard and adverse selection, one example each

Moral hazard: a shop owner who has full theft cover may stop paying for a good lock, so thefts happen more often than they otherwise would. Adverse selection: if premiums are priced for the average driver, careful drivers find them too high and leave, while risky drivers stay, so the insured pool is worse than average and claims exceed the plan. Insurers fight both with deductibles, screening and risk-based pricing.

Who makes sure trades settle?

Clearinghouses and custodians. Without them, strangers would not trade, because each would worry the other might fail to deliver.

A clearinghouse arranges final settlement, moving cash one way and securities the other. In futures it does much more: it becomes the buyer to every seller and the seller to every buyer, and it guards that guarantee with margin and limits on members’ positions. That is what limits counterparty risk , the risk that the other party fails to honor the contract. A custodian (or depository) holds securities for clients and protects against theft, loss and the same asset being pledged twice, including if a broker itself fails.

Go deeper How a clearinghouse margin system works

Members post margin and add to it when their positions lose money. The clearinghouse can use a failing member’s margin first, then its own capital, then capital drawn from other members. The Derivatives topic follows the daily margin cycle step by step.

Every intermediary in this lesson sells one of three things: a match, a pooled or repackaged risk, or a promise that the trade will settle.