D. describe types of financial intermediaries and services that they provide; Flashcards
Financial Intermediaries
entities
that stand between buyers and sellers
of financial assets and help to
arrange trades, settle trades, provide liquidity, create investment products
Brokers, Exchanges (electronic) and Alt. T. Sys. (electronic n allow clients to arrange trades amongst themselves)
connect buyers and sellers of the same security at the same location and time. They provide a centralized location for trading.
Brokers Brokers seek out traders that are willing to take the opposite side of their clients’ orders
Dealers match buyers and sellers of the same security at different points in time.
Dealers are traders who buy and sell for their own account. • Dealers provide liquidity—the ability to trade when you want to trade—to their clients. • Many dealers offer liquidity at exchanges where they generally will not know the traders with whom they trade.
Dealers buy securities from clients, with the expectation that they will be able to sell the securities to other clients in the future at higher prices.
Securitizers are financial intermediaries that assemble large pools of similar financial assets, such as mortgages or loans, and issue securities that represent interests in the pool.
Securitizers and depository institutions package assets into a diversified pool and sell interests in it. Investors obtain greater liquidity and choose their desired risk level.
Securitizers buy securities and repackage them as pooled securities. • The pooled securities may have different tranches, each of which is entitled to different cash flows and risk profiles. • The different tranches appeal to different clienteles.
Securitizers create pools of securities or loans and sell interests in these pools to investors
Banks provide demand and time
deposits and lend the proceeds to
borrowers.
connect borrowers to lenders. • Banks provide their depositors with transaction services (checking) and generally low risk liquid investments. • They provide their creditworthy borrowers with relatively low cost funds.
Investment banks are financial intermediaries through which corporations and other entities issue new securities to investors
Insurance Companies
Insurance companies create a diversified pool of risks and manage the risk inherent in providing insurance.
Insurance companies sell insurance contracts that allow people and companies to hedge risks. • The insurance companies hold large diversified portfolios of risks so that their average losses are predictable. • When diversification cannot eliminate risk, the insurance companies share out those risks with their shareholders and with reinsurers.
Arbitrageurs
Arbitrageurs connect buyers and sellers of the same security at the same time but in different venues. They also connect buyers and sellers of non-identical securities of similar risk.
• Arbitrageurs buy and sell correlated securities and contracts whose values depend on the same factors. • They provide liquidity to traders, in effect, by connecting buyers in one market to sellers in other markets.
Arbitrageurs buy an instrument in one market and simultaneously sell the same instrument in a different market at a higher price
Settlement and Custodial Agents
Clearinghouses reduce counterparty risk and promote market integrity.
Settlement agents help settle trades. – They provide escrow services. • Custodians safeguard securities and cash so that they are not lost through fraud.
block brokers
Block brokers assist their clients with large trades of securities
Block brokers are typically used to execute large trades in the secondary market
Ex 14 “Brokers and Dealers
What characteristic most likely distinguishes brokers from dealers?”
“Brokers are agents that arrange trades on behalf of their clients. They do not trade with their clients. In contrast, dealers are proprietary traders who trade with their clients.”
`
Ex 15 “Commercial Banks
What services do commercial banks provide that make them financial intermediaries?”
“Commercial banks collect deposits from investors and lend them to borrowers. They are intermediaries because they connect lenders to borrowers. Commercial banks also provide transaction services that make it easier for the banks’ depos- itory customers to pay bills and collect funds from their own customers.”
“EXAMPLE 16
Dealers and Arbitrageurs
With respect to providing liquidity to market participants, what characteristics most clearly distinguish dealers from arbitrageurs?”
“Dealers provide liquidity to buyers and sellers who arrive at the same market at different times. They move liquidity through time. Arbitrageurs provide liquid- ity to buyers and sellers who arrive at different markets at the same time. They move liquidity across markets.”
“EXAMPLE 17
Financial Intermediaries
As a relatively new member of the business community, you decide it would be advantageous to join the local lunch club to network with businessmen. Upon learning that you are a financial analyst, club members soon enlist you to give a lunch speech. During the question and answer session afterwards, a member of the audience asks, “I keep reading in the newspaper about the need to regulate ‘financial intermediaries’, but really don’t understand exactly what they are. Can you tell me?” How do you answer?”
“Financial intermediaries are companies that help their clients achieve their finan- cial goals. They are called intermediaries because, in some way or another, they stand between two or more people who would like to trade with each other, but for various reasons find it difficult to do so directly. The intermediary arranges the trade for them, or more often, trades with both sides.
For example, a commercial bank is an intermediary that connects investors with money to borrowers who need money. The investors buy certificates of deposit from the bank, buy bonds or stock issued by the bank, or simply are depositors in the bank. The borrowers borrow this money from the bank when they arrange loans. Without the bank’s intermediation, the investors would have to find trustworthy borrowers themselves, which would be difficult, and the borrowers would have to find trusting lenders, which would also be difficult.
Similarly, an insurance company is an intermediary because it connects customers who want to insure risks with investors who are willing to bear those risks. The investors own shares or bonds issued by the insurance company, or they have sold reinsurance contracts to the insurance company. The insured benefit because they can more easily buy a policy from an insurance company than they can find counterparties who would be willing to bear their risks. The investors benefit because the insurance company creates a diversified portfolio of risks by selling insurance to thousands or millions of customers. Diversification ensures that the net risk borne by the insurance company and its investors will be predictable and thus financially manageable.
In both cases, the financial intermediary also manages the relationships with its customers and investors so that neither side has to worry about the credit-worthiness or trust-worthiness of its counterparties. For example, the bank manages credit quality and collections on its loans and the insurance company manages risk exposure and collections on its policies. These services benefit both sides by reducing the costs of connecting investors to borrowers or of insured to insurers.
These are only two examples of financial intermediation. Many others involve firms engaged in brokerage, dealing, arbitrage, securitization, investment man- agement, and the clearing and settlement of trades. In all cases, the financial intermediary stands between a buyer and a seller, offering them services that allow them to better achieve their financial goals in a cost effective and efficient manner.”
Summary: “By facilitating transactions among buyers and sellers, financial intermediaries provide services essential to a well-functioning financial system. They facilitate transactions the following ways:”
1 Brokers, exchanges, and various alternative trading systems match buyers and sellers interested in trading the same instrument at the same place and time. These financial intermediaries specialize in discovering and organizing informa- tion about who wants to trade.
2 Dealers and arbitrageurs connect buyers to sellers interested in trading the same instrument but who are not present at the same place and time. Dealers connect buyers to sellers who are present at the same place but at different times whereas arbitrageurs connect buyers to sellers who are present at the same time but in different places. These financial intermediaries trade for their own accounts when providing these services. Dealers buy or sell with one client and hope to do the offsetting transaction later with another client. Arbitrageurs buy from a seller in one market while simultaneously selling to a buyer in another market.
3 Many financial intermediaries create new instruments that depend on the cash flows and associated financial risks of other instruments. The intermediaries provide these services when they securitize assets, manage investment funds, operate banks and other finance corporations that offer investments to investors and loans to borrowers, and operate insurance companies that pool risks. The instruments that they create generally are more attractive to their clients than the instruments on which they are based. The new instruments also may be differentiated to appeal to diverse clienteles. Their efforts connect buyers of one or more instruments to sellers of other instruments, all of which in aggregate provide the same cash flows and risk exposures. Financial intermediaries thus effectively arrange trades among traders who otherwise would not trade with each other.
4 Arbitrageurs who conduct arbitrage among securities and contracts whose values depend on common factors convert risk from one form to another. Their trading connects buyers and sellers who want to trade similar risks expressed in different forms.
5 Banks, clearinghouses, and depositories provide services that ensure traders settle their trades and that the resulting positions are not stolen or pledged more than once as collateral.”
