Traders are natural persons (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. In practice, traders usually don’t speak with clients or maintain client relationships.
For example, many mutual funds employ traders to carry out the fund’s objectives (e.g., a large-cap stock fund investing customer money into large-cap stocks). The fund manager sets the overall investment strategy, and the traders implement it by buying and selling securities for the fund. Traders working for large portfolios (like mutual funds) generally don’t have direct relationships with the investors in those portfolios.
Broker-dealers
Broker-dealers are financial organizations that help customers buy and sell securities. If you’ve ever placed a trade, a broker-dealer most likely handled it. Here are five of the largest broker-dealers (in 2024):
Assume you place a trade with your broker-dealer to buy shares of stock. When the trade executes, the transaction is locked in. At that point, you know:
How many shares you purchased
The price paid
Any applicable transaction fees
After execution, additional steps happen behind the scenes to settle (finalize) the transaction. The exact steps depend on the type of broker-dealer handling the trade.
Introducing brokers
Broker-dealers categorized as introducing brokers are often smaller firms that focus on customer relationships and trade facilitation. Introducing brokers don’t maintain custody of customer assets, meaning they don’t keep possession of customer securities.
Maintaining custody requires sophisticated technology and comes with strict recordkeeping requirements. Introducing brokers also don’t process their customers’ trades. Instead, they outsource these responsibilities to clearing brokers (discussed below).
To see how this works, walk through a simple example. Assume ABC Brokerage is an introducing broker with dozens of local customers. When a customer wants to place a trade, they call their representative at ABC Brokerage. ABC Brokerage provides customer service and takes the order, but the order is actually executed through XYZ Brokerage. In other words, the introducing broker (ABC Brokerage) hires a clearing broker (XYZ Brokerage) to maintain custody, process trades, and provide clearing services.
Clearing brokers
Many large broker-dealers are categorized as clearing brokers. These are broker-dealers that maintain custody, process orders, provide clearing services*, and facilitate trades for:
Their own customers, and
The customers of introducing brokers
*Clearing services involve clearing brokers working with clearinghouses to ensure a transaction will occur. Clearing brokers act as intermediaries between their customers (including introducing brokers) and clearinghouses. Clearinghouses are discussed below.
Clearing brokers must be properly connected to the financial markets to process orders. Broker-dealers offering these services are responsible for meeting “best execution” standards for their customers. In most cases, that means obtaining the best possible price.
Many securities trade in more than one market (often through multiple market makers, discussed below). If a stock is trading in five different markets, the clearing broker is responsible for finding the market that can execute the trade efficiently at the best price.
Clearinghouses
A clearinghouse is an organization responsible for making sure trades are properly finalized. As an investor, you generally don’t have to worry that a transaction will fail because one side doesn’t deliver what they owe.
For example, assume an investor sells stock at $50, but the buyer doesn’t deliver the required cash. Clearinghouses operate behind the scenes to prevent this from becoming the seller’s problem. The mechanics are more complicated than this, but the basic idea is that a clearinghouse would pay the seller out of its own pocket and then work with the buyer’s broker-dealer to be reimbursed. This kind of system is essential for confidence in the financial markets. Would you place a trade if you thought the contra-party (the other side of the transaction) might not follow through?
Clearinghouses are responsible for ensuring:
The buyer receives the security, and
The seller receives the cash
When a trade finalizes, the clearinghouse sends a report and the appropriate assets to the broker-dealers (clearing brokers) representing each investor (the seller gets cash, and the buyer receives securities). The broker-dealers update their records and place the appropriate asset in the customer’s account. If the customer uses an introducing broker, the clearing broker sends a trade confirmation to the introducing broker, who then informs the customer.*
*It’s important to understand what broker-dealers do, but the detailed “plumbing” of trade processing usually isn’t heavily tested on the exam. Focus on the basic roles and how they connect.
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