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 2021):
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.
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