Textbook
1. Introduction
2. Investment vehicle characteristics
3. Recommendations & strategies
3.1 Type of client
3.2 Client profile
3.3 Strategies, styles, & techniques
3.4 Capital market theory
3.5 Tax considerations
3.6 Retirement plans
3.7 Brokerage account types
3.8 Special accounts
3.9 Trading securities
3.9.1 Bids & offers
3.9.2 Short sales
3.9.3 Order types
3.9.4 Cash & margin accounts
3.9.5 Agency vs. principal
3.9.6 Roles in the industry
3.10 Performance measures
4. Economic factors & business information
5. Laws & regulations
6. Wrapping up
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3.9.6 Roles in the industry
Achievable Series 65
3. Recommendations & strategies
3.9. Trading securities

Roles in the industry

In general, there are six participants (roles) you’ll need to be aware of that operate in the securities markets:

  • Traders
  • Broker-dealers
  • Introducing brokers
  • Clearing brokers
  • Clearinghouses
  • Market makers

We will discuss other roles in the Laws & regulations unit, including agents, investment advisers, investment adviser representatives (IARs), and issuers.

Traders

Traders are natural persons (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. However, traders rarely speak with or maintain relationships with clients. For example, many mutual funds employ several traders to fulfill fund objectives (e.g., a large-cap stock fund investing customer money into large-cap stocks). The fund manager is responsible for creating the overall investment strategy, but traders implement it by buying and selling securities for the fund. Traders that work for large portfolios (like mutual funds) generally do not maintain relationships with their clients (those who invest in the portfolios).

Broker-dealers

Broker-dealers are financial organizations that help customers buy and sell securities. A broker-dealer most likely handled your trade if you’ve ever placed one. Here’s a list of the five 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 this point, you know exactly how many shares you purchased, the price paid, and any applicable transaction fees. After the trade execution, a few things must occur in the background for everything to be settled (finalized). The specifics depend on the type of broker-dealer handling the trade.

Introducing brokers

Broker-dealers categorized as introducing brokers are often smaller broker-dealers that primarily maintain relationships with customers and facilitate their trades. Introducing brokers don’t maintain custody of customer assets, meaning they don’t keep possession of their securities. Maintaining custody requires sophisticated technological infrastructures and comes with strict recordkeeping requirements. Additionally, introducing brokers do not process their customers’ trades. Instead, they outsource these responsibilities to clearing brokers (discussed below).

To better understand this, let’s work our way through an example. Assume ABC Brokerage is an introducing broker with dozens of customers in their local area. When a customer wants to place a trade, they call up their representative at ABC Brokerage. ABC Brokerage provides customer service and facilitates the trade, but the order is actually executed through XYZ Brokerage. Introducing brokers (ABC Brokerage) hire clearing brokers (XYZ Brokerage) to maintain custody, process trades, and provide clearing services.

Clearing brokers

Many large broker-dealers are categorized as clearing brokers, which are broker-dealers that maintain custody, process orders, provide clearing services*, and facilitate trades for their 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 appropriately connected to the financial markets to process orders. Broker-dealers offering these services are responsible for ensuring “best execution” standards for their customers. In most cases, this means obtaining the best possible price. Many securities trade in more than one market (by multiple market makers, which are 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 ensuring trades are properly finalized. Investors never need to worry about a transaction failing due to one side not fulfilling their end of the transaction. For example, let’s assume an investor executes a stock sale at $50, but the buyer doesn’t deliver the required cash to pay for the purchase. Clearinghouses work behind the scenes to ensure this isn’t an issue. It’s more complicated than this, but a clearinghouse would pay the seller out of their own pocket, then work with the buyer’s broker-dealer to ensure they are reimbursed. A system like this is essential to instill confidence in the financial markets. Would you place a trade if you knew the contra-party (the other side of the transaction) might not fulfill their end of the trade?

Clearinghouses are responsible for ensuring the buyer receives the security, and the seller gets 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 it’s a customer of an introducing broker, the clearing broker sends a trade confirmation to the introducing broker, who then informs their customer.*

*While it’s important to understand broker-dealers and their role in finance, the inner workings of trades are usually not heavily tested on the exam. Don’t get too frustrated if you’re confused. The financial system is complicated, but you only need to know the basics.

Sidenote
Settlement

As we’ve discussed, several protocols are followed behind the scenes after a trade executes. This is why settlement takes time, even in today’s digital age.

There are two types of settlement: regular-way and cash settlement. Most trades execute through regular-way settlement, the slower of the two options. Regular-way settlement for most securities occurs on the first business day after the transaction (known as T+1 - trade date plus one business day). Ensure you don’t count weekends or holidays towards settlement time frames, as settlement only occurs over business days.

Market makers

Market makers are organizations* that buy and sell securities solely on a principal basis (with inventory) to traders, broker-dealers, and other public customers. These organizations maintain ongoing bid & ask spreads and provide liquidity for the securities they trade.

*Most market makers are registered as broker-dealers - in particular, clearing brokers.

The last paragraph contains financial jargon, so let’s discuss the topic in plain terms. Assume you have a large inventory of pineapples (for whatever reason). If you put a pineapple stand in front of your house with a sign that said:

I will trade pineapples with anyone!

You can sell me one for $2, or
You can buy one for $3

You’re willing to trade pineapples with anyone, making you a pineapple market maker. The $2 quote is your bid (the price you’re willing to buy pineapples at), and the $3 quote is your ask (the price you’re willing to sell pineapples at). Your presence in the neighborhood makes buying and selling pineapples easy, which means pineapple liquidity is high. Liquidity would be even higher if multiple pineapple market makers existed in your area.

Now, replace pineapples with securities. Market makers buy and sell securities with the public and profit from doing so. They maintain bid and ask prices (discussed in more detail below), which enable profits while adding liquidity to the market. Broker-dealers send customer trades to the best market makers (typically with the best prices), who then fulfill the request. Traders and broker-dealers seek market makers with the best possible price to maximize client returns, so those with the best prices typically execute the most trades.

Sidenote
Payment for order flow

Many market makers engage in payment for order flow (PFOF), which compensates broker-dealers and other institutions for customer order traffic. Let’s continue with the pineapple market we discussed above to understand this idea better and again assume there’s a $2 bid, $3 ask, and a $1 spread.

You make many connections as a pineapple market maker. One of those connections is with a pineapple broker-dealer maintaining a large book of customers who regularly trade pineapples. You do not know these customers but would love to obtain their business. As we discussed, you make a $1 profit from every pineapple traded.

You and the pineapple broker-dealer enter into a revenue-sharing agreement. For every full pineapple trade you complete for their customers (buy a pineapple from one customer at $2, sell to another customer at $3), you will share half your profits ($0.50). While your profit margins decrease, you become more profitable overall as the broker-dealer sends hundreds of pineapple trades your way.

Replace pineapples with a security like common stock, and you have PFOF. Today, it’s a common practice for market makers to engage in PFOF with financial institutions, especially large discount brokers like Robinhood, TD Ameritrade, Charles Schwab, and E-Trade. These organizations send client trade requests to specific market makers in return for compensation. PFOF is one of the primary reasons firms like these can avoid charging commissions.

Broker-dealers are subject to best execution standards, which require routing customer orders to the venue or market maker offering ‘best execution.’ The definition of best execution is hotly debated in the securities markets and is currently being reviewed by the Securities and Exchange Commission (SEC). The big question is whether firms are prioritizing their customers or the market makers they are compensated by, especially given the term ‘best execution’ is unclear. Currently, the SEC defines it as:

The duty of best execution requires a broker-dealer to execute customers’ trades at the most favorable terms reasonably available under the circumstances

There are many proponents and critics of PFOF. Proponents claim it makes our markets more liquid and accessible, while critics claim investors are being taken advantage of through bad pricing. Some studies show investors (especially retail investors) being negatively impacted by PFOF, but typically only to the tune of a few pennies or less per share traded. For example, a broker-dealer diverts a customer trade to buy stock to MM1 (market maker 1) because of the PFOF paid by MM1, when MM2 would have executed the same trade for $0.01 cheaper per share, but with no PFOF for the broker-dealer.

There are some indications of this occurring in the real world. In 2020, Robinhood was fined $65 million by the SEC for practices related to PFOF. As quoted by the corresponding SEC press release:

As the SEC’s order finds, one of Robinhood’s selling points to customers was that trading was “commission free,” but due in large part to its unusually high payment for order flow rates, Robinhood customers’ orders were executed at prices that were inferior to other brokers’ prices. Despite this, according to the SEC’s order, Robinhood falsely claimed in a website FAQ between October 2018 and June 2019 that its execution quality matched or beat that of its competitors. The order finds that Robinhood provided inferior trade prices that in aggregate deprived customers of $34.1 million even after taking into account the savings from not paying a commission.

Regardless of the recent regulatory activity, PFOF remains legal and occurs regularly throughout the securities markets.

Key points

Broker-dealers

  • Facilitate and perform securities transactions for customers

Introducing broker

  • Broker-dealer that facilitates trades for customers
  • Does not maintain custody, process orders, or provide clearing services
  • Hires a clearing broker to perform the actions above

Clearing broker

  • Broker-dealer that maintains custody, processes orders
  • Acts as an intermediary (clearing service) between investors and clearinghouses

Clearinghouse

  • Organization responsible for clearing trades
  • Ensures buyers deliver cash
  • Ensures sellers deliver securities

Settlement rules

  • Most securities:
    • One business day after the trade (T+1)

Market makers

  • Buy and sell securities with the public
  • Acts only in a principal (dealer) capacity

Payment for order flow

  • Broker-dealers paid to send customer orders to market makers
  • Broker-dealers must abide by ‘best execution’ standards

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