Financial Intermediaries: An In-Depth Overview | CFA Level I Equity Investments

In this lesson, we’ll dive deeper into the different types of financial intermediaries and the essential services they provide in the world of finance.

What are Financial Intermediaries?

Financial intermediaries play a crucial role in any market, standing between buyers and sellers to facilitate the exchange of assets, capital, and risk. These services allow for greater efficiency and are vital to a well-functioning economy. Some key financial intermediaries include:

• Brokers and exchanges
• Dealers
• Securitizers
• Depository institutions
• Insurance companies
• Arbitrageurs
• Clearinghouses

Brokers and Exchanges: Facilitating Trades

Brokers help clients buy and sell securities efficiently by finding suitable counterparties for trades. They may work for large brokerage firms, banks, or at exchanges. Block brokers specialize in placing large trades that are difficult to execute without moving the market.

Exchanges provide a venue where different parties can trade with each other, sometimes even acting as brokers themselves by providing electronic order matching. They also regulate their members and require listed firms to provide faithful and timely financial disclosures.

Alternative trading systems (ATS) serve the same trading function as exchanges but have no regulatory function. They are also known as electronic communication networks or multilateral trading facilities. Many ATS are known as dark pools, as they do not display the orders that their clients send to them.

Dealers: Providing Liquidity and Profiting from Spreads

Dealers buy and sell securities directly from traders and maintain an inventory of securities. They provide liquidity in the market and profit primarily from the spread between the bid (buy) and ask (sell) prices. Some dealers also act as brokers and vice versa, which are called broker-dealers. However, there is an inherent conflict of interest between their roles as brokers and dealers.

Securitizers: Pooling Assets and Selling Interests

Securitizers pool large amounts of securities or assets and sell interests in the pool to investors. These asset-backed securities are typically divided into multiple tranches, each with varying levels of risk and return. This form of securitization allows investors to invest according to their required risk and returns.

Assets often securitized include mortgages, car loans, credit card receivables, bank loans, and equipment leases. Some asset-backed securities are securitized by firms that set up a separate legal entity called a special purpose vehicle (SPV) to buy some of its assets, making them bankruptcy-remote from the originating firm.

Depository Institutions: Banks and Their Role

Depository institutions, or banks, take customer deposits, pay interest on them, and provide transaction services. They then make loans to borrowers using the deposited funds, who pay interest on their loans, which forms the cash flows for the banks to pay interest on the deposits. Most banks have expertise in evaluating credit quality and managing the risk of a portfolio of loans of various types.

Other intermediaries, such as payday lenders and factoring companies, lend money to firms and individuals on the basis of their wages, accounts receivable, and other future cash flows. Securities brokers provide loans to investors who purchase securities on margin. When margin lending is provided to hedge funds and other institutions, the brokers are referred to as prime brokers.

Regardless of the type of depository institution, the deposits from depositors and the debt from lenders can be considered the institution’s liabilities on its balance sheet. Stockholders also supply capital to the institution, which forms the equity capital. The stockholders absorb any loan losses before the lenders and depositors, so the more equity capital an institution has, the less risk there is for depositors.

Insurance Companies: Managing Risks and Providing Protection

Insurance companies collect premiums in return for providing risk reduction to the insured. They can do this efficiently by providing protection to a diversified pool of policyholders, whose risks of loss are typically uncorrelated. Insurers act as financial intermediaries by connecting buyers of insurance contracts with investors, creditors, and reinsurers willing to bear the insured risks.

Insurance companies manage risks inherent in insurance, such as moral hazard, adverse selection, and protection from fraudulent claims. By doing so, they provide a valuable service to both policyholders and investors.

Arbitrageurs: Exploiting Market Inefficiencies

Arbitrageurs trade when they can identify opportunities to buy and sell identical or essentially similar instruments at different prices in different markets. They profit when they can buy in one market for less than they sell in another market. Arbitrageurs are financial intermediaries because they connect sellers in one market to buyers in another market.

Arbitrageurs differ from dealers in that dealers connect buyers and sellers arriving at different times in the same market, whereas arbitrageurs connect buyers and sellers arriving at the same time in different markets.

Clearinghouses: Ensuring Smooth Settlement of Trades

Clearinghouses act as escrow agents, transferring money from the buyer to the seller while transferring securities from the seller to the buyer. In futures markets, they also guarantee contract completion, making sure that both parties fulfill their contractual agreement.

For margin trades, the clearinghouse ensures that parties post sufficient margin and limit the aggregate net order quantity of their members. Through these activities, the clearinghouse limits counterparty risk, which is the risk that the other party to a transaction will not fulfill its obligation.

Custodians also improve market integrity by holding client securities. These services, which are often offered by banks, help prevent the loss of securities through fraud, oversight, or natural disaster.

Conclusion

By facilitating transactions among buyers and sellers, financial intermediaries provide essential services to a well-functioning financial system. Understanding the roles and functions of each intermediary helps us appreciate the complex web of interactions that underpin the world of finance.