Roles in the industry

In general, there are six participants (roles) you’ll want to recognize in the securities markets:

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

Other roles are covered 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. 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 underlying investors.

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’s a list of the five largest broker-dealers (in 2024):

• Vanguard Group
• Charles Schwab
• Fidelity Investments
• JPMorgan Chase & Co.
• Merrill Wealth Management

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 in the background to settle (finalize) the trade. The exact steps depend on what type of broker-dealer is handling the trade.

Introducing brokers

Broker-dealers categorized as introducing brokers are often smaller firms. Their main job is to maintain customer relationships and facilitate trades.

Introducing brokers don’t maintain custody of customer assets, meaning they don’t keep possession of customer securities. Custody requires sophisticated technology and strict recordkeeping. Introducing brokers also don’t process customer 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 this arrangement:

• The introducing broker (ABC Brokerage) works with the customer.
• The clearing broker (XYZ Brokerage) maintains custody, processes trades, and provides clearing services.

Clearing brokers

Many large broker-dealers are categorized as clearing brokers. These broker-dealers maintain custody, process orders, provide clearing services*, and facilitate trades for:

• Their own customers
• 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 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, this 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 ensuring trades are properly finalized. As an investor, you generally don’t need to worry about a transaction failing because one side doesn’t deliver what it owes.

For example, assume an investor sells stock at $50 per share, but the buyer doesn’t deliver the required cash. Clearinghouses work behind the scenes to prevent this from becoming the seller’s problem. The mechanics are more complex, but the basic idea is that a clearinghouse can pay the seller and then work with the buyer’s broker-dealer to get reimbursed. This kind of system helps maintain 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
• 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 useful to understand what broker-dealers do, but the detailed mechanics of trade processing usually aren’t heavily tested on the exam. Focus on the basic roles and how they connect.

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. They 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.

That last paragraph uses a lot of market jargon, so here’s the same idea in plain terms. Assume you have a large inventory of pineapples. If you set up a stand in front of your house with a sign that says:

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, so you’re acting as 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 makes it easy for others to buy and sell pineapples, which means pineapple liquidity is high. Liquidity would be even higher if multiple pineapple market makers existed.

Now replace pineapples with securities. Market makers buy and sell securities with the public and profit from doing so. They post bid and ask prices, which both:

• Create the opportunity for profit
• Add liquidity to the market

Broker-dealers route customer trades to market makers (typically those offering the best prices), and the market makers fill those orders. Traders and broker-dealers look for the best available prices to maximize client returns, so market makers with better prices tend to execute more trades.