101 Concepts for the Level I Exam
Concept 69: Types of Financial Intermediaries
Financial intermediaries facilitate transaction between buyers and sellers allowing them to exchange asset, capital and risk. The different types are:
- Brokers, Exchanges, and Alternative Trading Systems:
- Brokers: find counterparties for transactions (other entities willing to take the opposing side in a transaction) and do not indulge in trade with their clients directly.
- Block brokers: provide similar services as brokers, except that their clients have large trade orders that might potentially impact the security prices if the trade is executed without proper care.
- Investment banks: provide advice for corporate actions like mergers & acquisitions and help firms raise capital by issuing securities such as common stock, bonds, preferred shares etc.
- Exchanges: provide places where traders can meet. They regulate traders’ actions to ensure smooth execution of the trades.
- Alternative trading systems (ATS): serve the same trading function as exchanges but have no regulatory oversight. ATS where client orders are not revealed are also called dark pools.
- Dealers: trade directly with their clients by taking the opposite side of their trades. They provide liquidity by buying or selling from their own inventory and earn profits on the bid-ask spreads.
- They pool together large amounts of securities or assets. A special purpose entity (SPE) or special purpose vehicle (SPV) buys these assets and interests in this entity are sold off to investors.
- Assets that are often securitized include mortgages, car loans, student loans, credit card receivables and bank loans.
- Investors then earn returns from the cash flows of the underlying assets.
- Pooling of resources offers economies of scale, creates liquidity for these securities and reduces the total risk for these assets.
- Depository institutions: include commercial banks, savings and loan banks, credit unions and similar institutions that raise funds from depositors and other investors and lend it to borrowers.
- Insurance companies:
- They help entities offset risks by issuing insurance contracts that payout if a specified event occurs.
- The insured entity in turn pays an insurance premium for availing this benefit.
- The event risk is spread over large entities such that the total insurance premium earned is more than the insurance payout.
- Three key risks inherent in insurance system:
- Moral hazard: Insured entity is likely to take more risks.
- Adverse selection: Entities that are at most risk, are likely to buy the assets.
- Fraud: Entities claiming factitious losses or purposely indulging in damaging behavior.
- Clearinghouses: act as intermediaries between buyers and sellers, thereby lowering the counterparty risk and increasing the reliability of the trades.
- Depositories or custodians: hold securities for their clients. This helps prevent loss of securities through fraud, oversight or natural disasters.
- Arbitrageurs: indulge in buying and selling of mispriced securities and earn a riskless profit in the process. They provide added liquidity to the market by removing any price inefficiencies.